Below we draw important conclusions from our daily monitoring of key pricing and sentiment factors, much of them derivatives-markets based. We publish key conclusions ~monthly in cohesion with shifting conditions. Because many of our internal volatility factors shift daily, this note is intended to be about process – if you care about these markets and are interested in our high-touch (daily), 3-bullet point note, just shoot us an email us back.
The volatility head fakes in equities have been crushing market downside and outright volatility bets all year. If you hold a stock in a low vol environment, you don’t lose money. If you hold volatility, the decay gets more painful as time goes on (you lose money at an exponential pace), which leads to some of the vol smashes we’ve seen at each new all-time high in 2017.
As we wrote in this morning’s Early Look, the all-time high close in the S&P 500 index on Tuesday was met with implied volatility discounts across the major U.S. indices. This sequencing to us (high-end of risk range and compressing volatility expectations) is an important indicator of exhaustion. This volatility factor, among others, deserves important context which we try to provide below.
Our volatility factor overlay is an attempt to help us identify key short-term capitulation points (overbought, oversold) within longer term trends.
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Here are key takeaways and call-outs for the month to digest in bullet point form. We dive into each topic more extensively below:
- Currencies: With consensus still long Euros and other developed-market currencies and short Dollars from a net futures & options contract positioning standpoint, currency volatility expectations have picked up considerably over the last month. Currency and commodity volatility expectations are most divergent to the upside against equity volatility on the other side. Why? Because the past is projected into the future.
- S&P 500 and Russell 2000 vs. Nasdaq 100 and Tech (XLK) Expectations: These are two “growth” exposures that tend to do well in a QUAD 1 environment. Until mid-last week, there remained a wide divergence in volatility expectations (there still is to a certain extent). Russell 2000 implied volatility across factor exposure ETFs and expiries was at an all-time, complacent low ahead of the correction that started last week. On the other side of the spectrum, Nasdaq and technology FAANG fears have pushed volatility to a much more expensive point vs. broader equity market volatility. We outlined our view to fade the tech fear volatility in last month’s update: Tallying Votes: Nasdaq, Tech, Russell, Euro
- U.S. Equity Futures: In our June blackbook on CFTC positioning, we showed our study of open interest / average daily trading volume ratios in futures markets. In short, an extended ratio precedes volatility in almost every futures market. Right now we’re in the 99th percentile in S&P 500 e-minis, Russell minis, and Dow minis (more on this below) which should be a signal of risk on the surface.
- S&P Skew & IVOL Premiums: The largest global macro extensions in put skew can be observed in US equity indices. This in part has to do with at-the-money implied vol being pushed lower while downside protection is perpetually pinned at a lower bound (systematic downside and tail-risk index hedging). However, the downside vs. upside skew has also gotten extended the last few days – downside puts have gotten much more expensive than upside calls. Again, this is a beta chasing indicator. 95-105% skew in the QQQs is at its widest point of the year helped by the last couple of trading days. In other words, the price of a 5% downside put is at its most expensive point relative to the price of a 5% upside call.
- Updated short interest: In aggregate, U.S. equity market short-interest was held flat as a % of float m/m, helped by a sizable trimming in Telecom sector short-interest. Short-interest increased in just 3 of 11 sectors we track m/m (Energy, Consumer Discretionary, Consumer Staples).
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Currencies
With the market still long Euros and other developed-market currencies and short Dollars from a net futures & options contract positioning standpoint, currency volatility expectations have picked up considerably over the last month. Currency and commodity volatility expectations are most divergent to the upside against equity volatility on the other side. Why? Because the past is projected into the future.
The volatility term structures in both the USD (UUP) and the Euro (FXE) are now in backwardation. Short-term implied vol is trading at a higher level than longer dated implied vol. In a chart below we show the example of 6-Mth term structure. Volatility term structure backwardation is more common in currencies over other asset classes, but this set-up still usually represents perceived near term risk. The last 3 events that created term structure backwardation were the French elections, U.S. elections, and BREXIT. We’ll leave it to others to create narratives this time around.
In our macro themes presentation, we outlined the fundamental case for Euro weakness with some added market sentiment color suggesting long euro is becoming increasingly consensus. Although implied volatility premiums are now slightly positive again, other measures of sentiment like net futures & options positioning and volatility skew suggest long Euro and European growth from here remains a crowded position - we remain on the other side.
Looking at a z-score view of 95-105% skew (put 5% below last price vs. call 5% above last price), the Euro is among the most extended in global macro. This means that calls are more expensive relative to puts - the surface has flattened out.
Taking a more macro view by looking at currencies vs. other asset classes, the market expects the most volatility going forward in commodities and currencies, whereas the most suppressed volatility is expected in equity indices. We show this set-up in the last chart below, by aggregating four different contract expiries together into a single percentile reading to get the full mosaic view term structures in each market – the last few days haven’t changed this set-up. These divergent trends typically get stronger with time.
S&P 500 and Russell 2000 vs. Nasdaq 100 and Tech (XLK) Expectations: These are two “growth” exposures that tend to do well in a QUAD 1 environment. Until mid-last week, there remained a wide divergence in volatility expectations (there still is to a certain extent). Russell 2000 implied volatility across factor exposure ETFs and expiries was at an all-time, complacent low ahead of the correction that started last week. This uprooting of complacent expectations is fitting within the framework of what we should call “beta-fading volatility factors”.
On the other side of the vol smash in SPY and IWM, Nasdaq 100 and technology FAANG fears have pushed volatility to a much more expensive point vs. broader equity market volatility. This trend has reverted but this divergence has been pervasive for two months. We outlined our view to fade the tech fear volatility in last month’s update post July 4th vol blowout: Tallying Votes: Nasdaq, Tech, Russell, Euro
All-in-all these set-ups inform us that there is a crowd that remains anxious about the factor exposures that have outperformed in 2017. We’re not saying this anxiety isn’t prudent – clearly many investors with long-term track records have expressed concern.
U.S. Equity futures
In our June blackbook on CFTC positioning, we showed our deep-dive study of open interest / average daily trading volume ratios in futures markets. In short, an extended ratio precedes volatility historically. This conclusion was supported across durations and ratio thresholds (i.e. 80th or 90th percentile readings). It turns out to be a time-tested one-way volatility street.
Right now, futures market open interest to average daily trading volume ratios are in the 99th percentile in S&P 500 e-minis, Russell minis, and Dow minis (more on this below). And, as you can see in the second chart below, the step-up in forward volatility has tended to be most profound in equity futures markets.
S&P 500 Skew & IVOL Premiums
The largest global macro extensions in put skew can be observed in US equity indices. Put skew compares at-the-money implied volatility to downside strike implied volatility. The current set-up has to do with at-the-money implied vol being pushed lower while downside protection is perpetually pinned at a lower bound (systematic downside and tail-risk index hedging)….
However, the downside vs. upside skew has also gotten extended the last few days – downside puts have gotten much more expensive than upside calls. Again, this is a beta chasing indicator. 95-105% skew in the QQQs is at its widest point of the year, helped by the last couple of trading days – the price of a 5% downside put is at its most expensive point relative to the price of a 5% upside call. See the first two charts below – We show the relative shift in the volatility skew across durations with a Z-score view.
Updated Short Interest
In aggregate, U.S. equity market short-interest was held flat as a % of float m/m, helped by a sizable trimming in Telecom sector short-interest. Short-interest increased in just 3 of 11 sectors we track m/m (Energy, Consumer Discretionary, Consumer Staples).
So again the takeaway is that currency volatility expectations have experienced a sustained shift, including in the Euro. In equities, we can point to different volatility factors or liquidity ratios and conclude there’s “correction risk” embedded in current market structure and at all-time highs earlier this week, but our core views on equity factor exposures in a QUAD1 environment haven’t shifted after two days of trading.
Please reach out if you want to discuss anything above.
Ben Ryan
dty
