Via Goldman Sachs,
Question: Where are we now in terms of historical VIX levels and levels of S&P 500 realized market volatility?
Answer: The VIX is at 23.2, about 3 pts above its 1990-present average and 9 points above its 2013-2014 average.
The VIX landed at 23.2 last Friday. That is about three points below its median level of 26 over the last three recessions, 3.4 points above its long-run average of 19.8 back to 1990 and nine points above its 2013-2014 average of 14.2. S&P 500 one-month realized volatility currently stands at 31.7, ten-day at 26.7. A VIX trading well below short-term realized market volatility suggests the options market is expecting a moderation in market swings going forward relative to what we experienced in August. That may also mean that option investors are also expecting no hike this week.
Question: If the Fed doesn’t hike this week will the VIX go down.
Answer: Yes. 38% of recent SPX options flow has been short-dated and that flow may roll to longer maturities.
We do think the VIX moves lower if the Fed doesn’t hike this week. Why? Because options have an expiration date. There has been a tremendous amount of uncertainty priced post China’s currency devaluation plus additional uncertainty surrounding the September 17 meeting. Investors have flocked to short-dated weekly S&P 500 options to trade the recent market swings. We estimate that on a typical day since mid-August 38% of options traded on the SPX have had maturities of ten days or less.
That number has approached 50% over the last five trading days. If the Fed does not hike, hedges may be taken off or rolled out to later meeting dates. That could apply downward pressure on shorter-dated options, leading to a lower VIX. At the same time, that may just push out the duration or timing of the uncertainty; which could mean that the VIX could swing lower only to shift higher prior to the next few meetings.
Question: Even if the VIX calms down will it settle back into the low teens like it was from 2013 to mid-August 2015?
Answer: We don’t think so. The U.S. economic landscape & cross asset metrics both suggest a VIX in the high-teens.
Point 1. The business cycle: In last week’s edition of The Buzz we estimated that baseline VIX levels of 18 would be justified given the current U.S. economic landscape. Our point is not that the VIX will go to 18 tomorrow. It is that trend VIX levels should now be 4-5 points higher than the average level of 14 experienced in 2013-2014 given the current state of the economy. In the same way that we have argued that VIX levels in the high 20’s and above are consistent with recessions (and therefore the VIX should have dropped over the past couple of weeks) we also argue that VIX levels in the high teens are more consistent with the current ISM level in the low 50’s. VIX levels in the low teens are more consistent with ISM levels in the upper 50’s.
Point 2. Cross asset risk levels are higher: Our benchmarking work in the last two editions of The Buzz suggested that VIX levels were around 5 points low relative to EM FX, U.S. HY spreads, oil and rates moving into mid-August. Our point here is that if the VIX was listening to other markets then baseline levels of 18-19 would have been justified in mid-August before the equity decline. While the economic data could improve, at the current time the U.S. economic picture and cross asset analysis both suggest similar baseline VIX numbers of 18-19.
The counterpoint to the thesis that a VIX in the high-teens may be justified would be that with so much short-dated option flow in the system, if the Fed doesn’t hike, the VIX might collapse as investors trade out of shorter-dated options. There are few data releases between the September and October to convince the committee to hike in October, which leaves the VIX with two months to potentially swing lower. Options markets are clearly focused on EM as well therefore a VIX collapse back to the low teens may require a global reduction in risk, which might take a while.
Question: How have equities and the VIX reacted around past rate hikes?
Answer: Equities lower on moderate volatility.
In the remainder of this report we focus on how S&P 500 returns, VIX and SPX realized volatility levels have reacted around past rate hikes. Our analysis shows that while equities do tend to be lower one-, two-, and three-months after a Fed rate hike, S&P 500 realized volatility and VIX levels have been fairly well contained. One argument for why that has happened is that the Fed doesn’t tend to hike into a weak economy. U.S. GDP rates and ISM levels have been strong surrounding the first rate hike. What worries many investors now is that if the Fed does hike this week they would be hiking during a period of high uncertainty surrounding the U.S. and global economic landscape at the same time that financial conditions have been deteriorating. The cushion may simply be lower now than in the past. The implications and potential imbalances around six years of zero interest rates and global central bank adjustments have also worried investors. If the Fed does hike this week equities may take it poorly unless the communication is for a slow normalization path.
S&P 500 returns are typically lower once the Fed starts raising rates
We analyze S&P 500 returns and peak to trough max drawdowns prior to and post the last three rate hike cycles.
S&P 500 returns and max drawdowns prior to the initial rate hikes in 1994, 1999, 2004
- S&P 500 returns prior to each rate hike were positive: Median S&P 500 returns were +5%, +7%, and +17%, during the 3-, 6-, and 12-months before the initial hike. The S&P 500 was up 3/3 times in the month prior by a median of +2.9%. We take that to mean that good news was good news and the S&P 500 was responding to a stronger economy.
- Max Drawdown Analysis: While returns three months leading into the first rate hike were positive over each of the three periods, the ride was not always smooth. The maximum peak-to-trough S&P 500 returns in the three months prior to each rate hike were: -1.6%, -6.3% and -5.8% in 1994, 1999 and 2004, respectively.
S&P 500 returns and max drawdowns post the initial rate hikes in 1994, 1999, 2004
- S&P 500 Returns on the day the Fed hiked rates were -2.3%, 1.6% and 0.4% with a median return of +0.10% one-week after the Fed started raising rates. S&P 500 returns were negative one-, two-, and three months after each initial rate hike across each period. The median S&P 500 return was -5.9% three-months post rate hike.
- Max Drawdown Analysis: Peak to trough drawdowns were larger after a hike than before. We estimate that the max drawdowns three-months after a rate hike were -7.2%, -10.6%, -6.8% (1994, 1998, 2004).
The impact of rate hikes on volatility has historically been muted
S&P 500 realized volatility levels in 1994 and 2004 were low going into and sub-10 coming out of the first rate hike. The maximum level of S&P 500 1m realized volatility in the year prior to the 1994 and 2004 rate hikes was 17.1 with a max VIX level of 22.7 on a rolling daily basis. One-month realized volatility was sub-10 one month after both initial hikes and the maximum VIX level in the one-month surrounding the initial hikes was a modest 17.3. VIX levels three-months after the initial hike were 16.2 and 13.2 in 1994 and 2004, respectively.
The first rate hike in June of 1999 was sandwiched between the fallout from Long Term Capital Management over the back half of 1998 and the bursting of the tech bubble in the spring of 2000. In short, realized volatility was elevated coming into 1999. That said, realized volatility declined into the June rate hike and was also lower 1m later. One-month realized volatility levels were around 20 one- and three-months prior to the first hike and were lower afterward; at 14, 19 and 18, one-, two- and three-months after the hike. Higher levels of realized volatility meant that VIX levels were also higher in 1999 relative to 1994 and 2004. The VIX landed at 21.1 on the day of the rate hike and was 24.6 and 26.5 one- and three-months after the first hike.
Bottom line: While S&P 500 returns were lower post the last three rate hikes, S&P 500 realized volatility and VIX levels were moderate, with no volatility spikes.
