The surge in the Chicago Board Options Exchange (CBOE) volatility index (VIX) to a record close of 82.69 on Monday 17 March 2020 prompted industry participants to sit up, as the last time the index breached the 80 mark was on 20 Nov 2008 (closing at 80.86) during the Global Financial Crisis.
As the VIX is widely followed as a “fear index” for the US market, some may read this to imply that the market is at its “maximum fear” point.
Circuit breakers across US and Asian equity markets have been given a thorough workout. Measures of volatility in equity, interest rates and currency markets have surged, while credit spreads have significantly widened as the Covid-19 virus scare and oil shock ricochets through markets. Such a surge in volatility is normally associated with markets bracing for US economic recession or risks of a financial crisis.
This spike in volatility across asset classes arose from the rapid spread of the Covid-19 virus in the US, Europe and Middle East from its original epicentre in China and Asia. The situation was worsened by the plunge in oil prices set off by the impasse among OPEC+ countries.
Amid the lack of visibility around the spread of Covid-19, which epidemiologists predict could last for months or even years, initially tardy responses by policy makers worldwide made matters worse. Financial markets started to price in bear-case scenarios that the healthcare pandemic would precipitate a global recession.
In response to the first phase of sharp equity market corrections, early signs of USD funding stress and tightening credit conditions, the Federal Reserve responded firmly by slashing its Fed funds rate by 150 basis points (50 bps on 3 March, 100 bps on 15 March) to 0.0-0.25% and announcing an initial US$700 billion of bond purchases.
The Fed has since launched an onslaught of other measures, including expanding its commitments to buying unlimited amounts of government and private sector bonds as needed to support companies’ short term funding needs, and an alphabet soup of programs aimed at relieving stresses in money markets. As an indication of the scale of its intervention, the Fed’s balance sheet has ballooned to US$5.3 trillion for the week ended 25 March vs. US$4.7 trillion the week before.
On 27 March, US President Trump signed into force a US$2 trillion emergency stimulus bill approved by Congress – the largest in US history – to support the economy and cushion it from the worst effects of the Covid-19 pandemic. The US$2 trillion stimulus package comprises a laundry list of loans, payments and benefits – including rebate checks, small business loans, one-time payments of US$1,200 each to eligible Americans, extended unemployment benefits and US$500 billion in Fed funding for business grants, targeted at specific industries such as airlines and hotels. And to the healthcare complex, the package presents a US$27 billion emergency fund to cover vaccines and medical supplies, US$100 billion for hospitals and US$150 billion for coronavirus-related costs.
In Europe, the European Central Bank launched a new quantitative easing program on 18 March worth EUR750b comprising emergency buying of private and public sector bonds at least until end-2020, on top of an earlier EUR120b bond-buying commitment, and improved terms on its targeted programme to stimulate bank lending. Germany is preparing to create a EUR500b bailout fund to help companies, and has also set aside an extra EUR122.5b in spending this year to cushion the shock of Covid-19 on the German economy.
Yet, the volatile market conditions persist.
Exhibit 1: Measures of volatility in equity, interest rates and currency markets have surged
Note: The MOVE Index is a measure of US interest rate volatility
Source: Bloomberg; as at 19 March 2020
Volatility: The tail that wags the dog
The combination of liquidity conditions and volatility itself is exacerbating the erratic spikes across asset prices for equities, credit markets, index futures, the US dollar and even gold.
Market dynamics such as the unwinding of option positions and the prevalence of CTAs and hedge funds employing systematic quant-driven trading strategies have created a non-linear response in financial markets, which would take time to stabilise in the short term.
With the spike in volatility across asset classes, fund managers with cross-asset portfolios built upon risk parity or risk control strategies would need to pare down risk by selling down liquid assets such as equities, ETFs or bonds to rebalance into lower risk assets such as cash, gold or treasuries. The combination of rebalancing and redemptions of mutual funds, hedge funds and ETFs has led to dislocations in liquidity conditions.
With the unwinding of derivatives and structured products to alleviate margin calls by banks for wealth management clients, as well as institutional investors, traders at investment banks would in turn need to unwind their hedges.
If liquidity for these assets and underlying options is low, there would be sharp swings in share prices and futures markets. Some derivatives with kick-in features would also be activated with the sharp drops in underlying shares and indices.
With events such as the sharpest one-day S&P 500 index sell-off in its 20-year history (-9.5%) last week, which are followed by short term rallies and corrections, market participants witness participation of traders who were unwinding “short gamma” positions. Such positioning arises when realised volatility far exceeds the traders’ expectations (implied volatility) and their response to cover shorts can exacerbate the moves in the volatility futures market (as evidenced by the VIX index and index futures).
Are we at "peak volatility" and does that signal a bottom?
With the Fed and US Treasury’s “all-in” response to employ fiscal, monetary and healthcare measures, should investors expect the worst to be over?
Unfortunately, we are not there yet.
As a reference, during the Global Financial Crisis of 2007-8, the Fed cut rates to zero in Dec 2008 but the relief rally was short-lived and lasted only a month. The S&P 500 index declined 20% from then, and only bottomed in March 2009. The current “Global Coronavirus Crisis” situation in 2020 is markedly different from the 2007-8 crisis, when stress in the housing market sparked a financial crisis that called for monetary and liquidity lifelines.
The chart below indicates a relatively weak correlation between the VIX and S&P 500 index in terms of timing.
Exhibit 2: VIX and S&P 500, past 10 years
Source: Bloomberg; as at 19 March 2020
For the capital market to find its feet, we would need to see 1) decisive and coordinated policy response global across fiscal, monetary and healthcare policies; 2) a convincing slowdown in number of new cases around the world; 3) easing credit conditions aided by aggressive liquidity injections; and 4) deep value to emerge in terms of valuations, given the decline in earnings visibility.
What should investors do?
Behavioural finance speaks of the tendencies for investors to be susceptible to biases when making investment decisions.
In periods of extreme stress in markets, investors can be over-confident in a rising market and exhibit excessive loss aversion in a falling market. This explains why investors are more inclined to take profits than cut losses.
We encourage investors to observe the discipline of managing risks through diversification, maintaining sufficient liquidity and building resilient portfolios.
As market liquidity is scarce and volatility persists, ensure that portfolios have sufficient cash to weather the short term volatility and manage leverage within portfolios.
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Version: March 2020