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Volatility (VIX) is now at its lowest level since before the August sell-off last summer yet CS Fear Barometer remains elevated leaving the spread between the two options-market-based indicators is at its widest ever.

Credit Suisse sees two main reasons for the difference:

1) VIX measures just vol whereas CSFB reflects skew (i.e. Demand for puts vs. calls) The skew being elevated is a function of the upside calls being sold broadly in the market plus portfolio hedging; and

2) CSFB is a 3-month forward look — ie around time of brexit and other potential catalysts)

But as Goldman Sachs details, with the unemployment rate at 5% the ISM manufacturing index at its current level of 51.8 suggests a VIX level of 19.2. The much higher new orders index (58.3) suggests a VIX level of 16.7. So the VIX is currently pricing further economic improvement…

 

As the market itself seems to shrugg off the collapse in earnings expectations

 

However, Goldman adds, while volatility may be subdued for the next few weeks, perhaps until the next potential major catalyst, such as “Brexit”, if our economists are correct, Fed chatter may pick up again in H2… which is supported by the fact that investors are pouring money into levered long VIX ETPs.

Investors often chase strong performance but that has not been the case across the VIX ETP space. As the VIX has fallen, investors have been positioning for a rise in volatility via double levered long ETPs.

Levered VIX ETP vega exposure has doubled since the market trough, driven by longs. We monitor vega exposure for a select group of 11 VIX ETPs, with around 4 billion in total market cap. We estimate that the gross vega notional across levered VIX ETPs now stands near a record high at around 244 million vega (in absolute terms), more than doubling since the market bottom in February. The increase has mostly been driven by long and double-levered long VIX ETPs, such as the UVXY and TVIX.

Volatility investors are often interested in how much volatility exposure (vega) VIX ETPs carry and what percentage of the overall VIX futures market they account for.

How big is the VIX ETP market? We estimate that the gross vega exposure controlled by the six most active VIX ETPs (VXX, VIXY, UVXY, TVIX, XIV, SVXY) which track the front month future is currently running at 320 million vega, which accounts for about 85% of the outstanding open interest in the VIX futures market.

Simply put, as Goldman sums up, the options market seems to be questioning the quality of the rally and continues to price in more adverse outcomes.

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