Junk-bond prices are at all-time highs, stocks are touching five-year peaks and the market’s so-called fear gauge has tumbled to a five-year low. But some strategists are worried this optimism is misplaced just weeks ahead of what could be a bitter political brawl over U.S. borrowing limits.
If the July and August 2011 debt-ceiling debate is any guide, markets appear too complacent. In those two months, the S&P 500 declined 17% from peak to trough, and the market’s fear gauge, the Chicago Board Options Exchange’s Volatility Index, or VIX, roughly tripled from 16 to 48, reaching its highest level in the post-financial-crisis era. The VIX is calculated from the prices investors are willing to pay for options tied to the S&P 500 index. It is often used to hedge stock investments because of the way it tends to rise as stocks fall.
With Republicans expected to use the debt limit as a bargaining chip to cut spending and President Barack Obama calling that stance “absurd” Monday, the potential for volatility to spike in the coming weeks is higher than usual, some strategists say. Yet the VIX has traded below 14, near its lowest levels since June 2007, for the past eight sessions.
“The VIX looks exceptionally low for what many believe will be significant events come late February,” said Edward Marrinan, credit strategist at RBS Securities. If one value of the VIX is to measure uncertainty in the world, he added, “I don’t think it’s doing that in a timely or reflective manner.”
But many options strategists don’t perceive a contradiction between a low VIX and the upcoming debt ceiling, largely because the 2011 experience isn’t a perfect guide. At that time, investors had other worries, too, including fears the U.S. would slip back into recession and that the European debt crisis was spreading.
“We’re in a different economy than we were [in August 2011],” said Joe Kinahan, chief derivatives strategist at TD Ameritrade. “We still have a fragile economy, but it is very different, and there isn’t as much fear that this one single event could knock us off course.”
The VIX added 0.15 point, or 1.1%, to 13.67 Tuesday.
Still, USAA Investments, a San Antonio, Texas-based firm that manages $12 billion, has cut its holdings of equities and raised its exposure to high-grade bonds in anticipation of market turbulence in the coming weeks.
“Volatility can resurface suddenly,” said John Toohey, vice president of equity investments at USAA, in a Monday note. Toohey is concerned a political failure could lead another ratings firm to strip the U.S. of its triple-A marks, “which could produce a similar pullback to what we saw in 2011.”
When S&P Ratings Services downgraded the U.S. to AA-plus on Aug. 5, 2011, it sent equity markets into a tailspin, while Treasurys rallied. But some investors say that the shock-value of losing the AAA status has worn off, so the consequences of another downgrade from Moody’s or Fitch would have little consequence.
“I do not feel like there’s too much complacency,” said Brian Hess, portfolio manager at Brandywine Global Investment Management. “We’ve already lost the triple-A rating–the sacred cow is gone. If Moody’s takes us down, we don’t think markets would plunge the way the chaos unfolded in 2011.”
A second downgrade technically would place the U.S. credit rating in the double-A category, causing some funds restricted to owning triple-A securities to sell Treasurys. That wouldn’t necessarily damage the safe-haven status or liquidity of Treasurys, however, so it isn’t clear if borrowing costs would rise.
Many options traders say the VIX remains in line with recent stock-market moves.
A backward measure of the VIX reflecting actual volatility over the past 30 days stood at just 12.24 Tuesday, according to data firm Livevol. That is 10% below the current VIX level.
Investors looking to protect against market declines via options may wish to wait until the key dates in the debate come nearer, as a significant part of option pricing includes the amount of time remaining until the options expires. Buying protection now–which would drive up the VIX–could be more costly.
“The debt ceiling debate isn’t expected to heat up until next month. And, especially with a day off a week from today, investors don’t want to lose the extra money by investing now,” said TD Ameritrade’s Kinahan, in reference to the upcoming Martin Luther King Jr. holiday in the U.S. on Monday.
If the VIX were to jump, the increase in volatility could offset savings from waiting to initiate options positions. But as long as the VIX remains near its recent lows below 14, investors benefit from waiting it out.
VIX futures are, in fact, pricing in a jump in volatility next month: Futures contracts expiring Feb. 13 traded at 15.90 Tuesday, while March contracts were at 17.30. A VIX of 15.90 implies a daily market move in the S&P 500 of about 1%, while 17.30 prices in daily moves of 1.1%. The size of the daily implied move rises just 0.06 percentage point with each one-point increase in the VIX. That means the August 2011 VIX reading of 48 implied a daily market move of 3%.
“This time around, it really is all about U.S. politics, rather than about whether the sky is falling,” said Ophir Gottlieb, managing director of client support and algorithmic trading at Livevol.
Source: The Wall Street Journal
