The Vol Shock Heard 'Round the World

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry. Alpha Exchangers, welcome to a special 50 VIX episode of the podcast.

[00:00:24] As I share some thoughts on these truly historic times, let me just say that for those like me that live in the tales of the distribution, today's environment amounts to being a kid in a candy store. Market prices are singing out loud, singing proud. Vol is high, vol-a-vol is high. I'm tempted to say that even vol-a-vol-a-vol is high, but I'm not sure that's a thing. On a note unrelated to markets, I'm headed to see Glengarry Glen Ross on Broadway this week.

[00:00:53] I do love me some Kieran Culkin and Bob Odenkirk. It turns out that also in the play is Michael McKean. You may remember him as Chuck McGill from Better Call Saul, or if you are even remotely close to my age, as Lenny from Laverne and Shirley. Hello, Laverne. I'm also a big fan of Bill Burr and have seen him in concert countless times. His support of Luigi Mangione is getting to be a bit much, I must add.

[00:01:18] Still, I'm looking forward to this even if there's no AIDA, Attention, Interest, Decision, Action, from someone playing Alec Baldwin. I'll report back in short order. There are decades where nothing happens and there are weeks where decades happen. That comes to us not from Vladimir Putin, but from Vladimir Lenin. At least that's what is suggested. Like Mark Twain, perhaps Lenin is given credit for a few catchy sayings he didn't actually come up with.

[00:01:46] But it's an excellent turn of phrase. To be sure, it's impossible to argue that nothing has happened in the last decade. Just ask Vladimir Putin himself. But you get the point. And it's difficult to understate how highly consequential these past few days have been. I'm no international trade guru, nor do I have any plans to become one. I'll leave what will amount to ongoing guesswork to those folks and economist types.

[00:02:12] But I am engaged in the study of market prices and do so with the valuable benefit of having been in a derivative seat helping large counterparties navigate each of the market stress episodes over the last three plus decades.

[00:02:26] With this in mind, I've got a few observations on the price action, many of them through the lens of derivatives markets and brought to life through some of my own catchphrases. I'm a simple fellow, and keeping track of my house keys and passwords is hard enough. To understand markets, I need aphorisms, adages, and pithy proverbs. So let's get into it.

[00:02:53] First, I am reminded of my view that, quote, realized vol rules the world. Consecutive 4% down moves in the S&P are a rare event. Including this past week, there's only the GFC twice in November 08 and COVID. Everything underlined and in bold everything in markets is a reaction to realized vol. Option prices respond immediately as the cost of hedging delta risk balloons

[00:03:21] when 10-day realized vol in the S&P goes from 17 to 47 in two days. If you don't trade options, you care anyway about much larger daily swings at the index level. Realized vol spikes of this magnitude make your portfolio much larger, increasing your daily value at risk without you having lifted a finger. You want the same VAR? You need to get smaller. The process of de-risking, either through hedging or outright selling,

[00:03:49] reinforces an already fragile environment. The market can't withstand many more shocks of this magnitude. The VIX spent a fair amount of time in the 50s on Monday, April 7th. You'll recall that while it was kind of a flash-up crash into the 50s on August 5th of 2024, that was a fleeting event. This is not. The precedent for a 50 VIX is rather ominous. It's really just the GFC and COVID that got past 50,

[00:04:18] and both times we were on our way to 80. To be clear, neither of the motivating, destabilizing circumstances that drove those events is in place now. There is no unwind of a massive mortgage credit bubble with huge vulnerabilities resulting from the demise of Lehman and AIG. With respect to the market storm five years back, there is no intentional shutdown of the U.S. economy present now. So we do have that going for us.

[00:04:48] I hear all the time on X, that social media platform formerly known as Twitter, that you can't trade the VIX. Folks get pretty hot on this topic, and I'm not entirely sure why. It is true there's no security called VIX that you can buy and sell. But you can buy and sell securities that track the VIX with incredibly high precision. And that is roughly one month, 5% out of the money put vol on the S&P 500.

[00:05:15] As I showed on X, these move basically in lockstep. And we know how changes in that implied vol translate to changes in the option price. So I like to think of the VIX simply as an insurance cost index. If we use 55, for example, as the vol input on a 5% out of the money, one month put on the S&P 500, we get a cost near 4%. Now, we all encounter insurance, folks, in our daily living.

[00:05:44] Car, homeowner, travel, health, life. You can insure your boat, your pet. You can take out an extended warranty on your TV. You get the idea. Most of these feel overpriced. Let's consider for a moment the cost of this 5% out of the money put on the S&P. You absorb the first 10% of the downside. You pay 4% up front. Oh, and the insurance lasts for just a month. Ouch. Financial market insurance is a weird thing.

[00:06:13] Interest in buying it tends to spike at the wrong time. At some point, the cost of insurance becomes simply unaffordable and too high. And when the overlay hedge ceases to be reasonable in price, that promotes further portfolio de-risking. From a market standpoint, the higher vol goes, the greater likelihood that government officials blink in some way. The scars from the market chaos of the GFC and COVID remain. Lutnik's, quote,

[00:06:41] These tariffs will remain for days and weeks is far from money good if asset prices plunge and vol spirals higher. You simply wind up creating really hard to fix but also urgent problems when that happens. And folks like Scott Besant know that. I like the quote from Niall Ferguson, quote, The only real law of history is the law of unintended consequences. We live in a pretty interconnected world of international rivalries, debt, trade, asset prices, economies, etc.

[00:07:10] All kinds of tail probabilities, or tail possibilities at least, become more alive when a shock of this magnitude occurs. I'm in the camp that we're setting up for a nicely tradable reversal of unsustainably high VIX levels. As always, calling a top is impossible. And I wouldn't outright short VIX futures or calls or S&P vol. But the beauty of VIX options is that you can express a premium contained view on vol going lower

[00:07:37] through various combination of puts, 1x2 put spreads, etc. About Fannie and Freddie, Bill Gross famously said in 2008 as the GFC was heating up, Shake hands with the government and buy what they're buying. There may be a chance to shake hands today and sell what they're selling, that is, the VIX. They won't be able to execute on any policy with the VIX up here for an extended period of time.

[00:08:03] A 50 VIX is a market moving 3 plus percent every day. That reflects an incredibly unhealthy risk-taking and most likely economic environment. And that brings me to a second little scribble on my cheat sheet. Vol has memory, vol mean reverts. We know that vol events tend to cluster. As highlighted, we just got successive 4% down days in the S&P. These episodes of uncertainty also bring about big up moves.

[00:08:32] In fact, if you look at history, you'll see that the biggest up days in the S&P always occur during the large market shocks. Since 1990, the S&P has 12 6% up days, all of which were realized during the GFC in the pandemic. This is the memory part of vol. When the market is forced to process a sea change in policy or in its understanding of the state of the world, examples, subprime is not contained.

[00:09:00] A developed market sovereign can default. Volatility can gather a dangerous energy when this happens. It is this same risk, however, that almost demands policy response from policymakers. Will Trump, Besson, Powell blink? When the market finds itself short of risk-bearing capital, it's often the case that some combination of monetary policy easing and the provision of public capital or some version of a backstop

[00:09:28] play a role in arresting the problem and causing vol to mean revert. Some basic detente would go a long way towards lowering risk premium levels. I often say that risk-on and risk-off are curious cousins. The mean reversion of vol is nearly guaranteed, even if not easily timed. What was that combination of QE, Fed and Treasury rescue facilities, tax cuts, and promises to hold rates at zero that allowed the S&P to bottom in March 2009?

[00:09:57] It is difficult to know. With the benefit of hindsight, it's easy to stitch together the logic that the bottom was in, but in real time, option prices suggested a more than 50% probability that the S&P could be below 500 by the end of 2009 during that March low. However, we should recognize that the history of market dislocations often creates trading opportunities on the long side.

[00:10:23] When the VIX is at 45, you're getting paid really well to provide insurance capital to the market. Here's an example. Just two months ago, the cost of a two-month 10% out of the money put on the S&P was 30 basis points. It's now seven times that amount at 210 basis points. So if you're in the business of collecting such premiums, you raise the same nominal amount and can be one-seventh the original size.

[00:10:51] That put carries an implied volatility near 40%. And while it certainly can't compete with the insanity of the COVID crash, it's higher than anything we've seen since the GFC. Remember as well that policymakers do tend to blink when markets get chaotic enough. You sell vol into these events because you anticipate the unlimited deep pockets of the government may also sell vol to stabilize markets. The key, of course, is sizing.

[00:11:20] Even as we focus on trying to find attractive entry points that are facilitated by some combination of asset price damage and high levels of risk premium, we cannot dismiss that a 50 VIX is a dangerous backdrop. It was Michael Rourke of Jones Trading who said, quote, broken markets break down. I really appreciate how efficiently this captures the nature of markets.

[00:11:45] While a dislocation of this magnitude has historically paved the way to collect risk premiums, we have to respect that things break when market prices move this fast. This is the ninth 10% drawdown since and including the GFC. At nearly 18%, this one is substantial. There's no way around it. We know that market prices respond first and have predicted 10 of the last two recessions, as they say.

[00:12:12] There are going to be some ongoing sources of feedback. Between asset prices and the real economy and vice versa. Between the administration and markets. Between the rest of the world and the administration. Between the Fed and the markets and the Fed and the data and vice versa. My own scars from episodes like long-term capital management, the GFC, and COVID, is that modern markets mostly, but not always, can self-correct.

[00:12:38] The old adage, the cure for lower prices is lower prices, sometimes does not apply. Markets break. They can topple without backstops. I also point out that the electronification of liquidity provision, an absolute feature of modern markets, is local vol dampening, but may leave vulnerabilities to tail outcomes. For example, how did the S&P options market turn so illiquid the way it did on August 5th of 2024?

[00:13:07] As we've experienced consecutive enormous daily shocks at the S&P level, what's the impact on the risk-bearing capacity of the system? I'll note that the CBOE just published a piece in which it found that 47% of all options traded in 2024 had expirations between zero and five days. These are new instruments in the derivative space that at least potentially create risk dynamics that we cannot yet fully appreciate.

[00:13:35] In the ETF landscape, we've also seen significant innovation. To be clear, this is not your father's ETF market. Not even close. NVLD, SMST, NUGT, SOXL, YIN, Yang. These are all leveraged ETFs with daily resetting exposures. They have a simple mandate. Delivered two times and sometimes even three times the daily positive or negative return

[00:14:04] on an underlying index or equity. In the case of MSTU and MSTX, delivering two times leverage on top of the Michael Saylor sound machine, MSTR, the feedback with respect to volatility was profound back in November 2024. The key point on these products is that both the leveraged long and leveraged short re-hedge in the same direction

[00:14:30] and can serve as amplifiers of volatility in the underlying, sometimes substantially so. Let's look at TQQ and STQQ, 3X leveraged long and short respectively on the QQQ. On Friday combined, these two ETFs saw a volume of nearly 500 million shares.

[00:14:54] TQQ, the long version, has seen its AUM fall from $25 billion to $14 billion since mid-February. Market risk changes because the products that populate the market are always evolving. There are no CPDO squareds to look after right now, but there are daily resetting ETFs. Many of these use derivatives, accessing the leverage through a swap counterparty. For TQQ, hit up the MHD function on Bloomberg and see all of the swaps it uses.

[00:15:24] When vol gets this high, swap counterparties may decide the carry to be earned for taking the financing risk is no longer a good deal. This gets back to realized vol rules the world. Fresh decision-making occurs when vol is restruck so much higher. This can create knock-on effects. The mechanical rebalancing that TQQ and SQQ had to do on Friday added nearly 20 million shares to sell in an already massively downed tape.

[00:15:53] Let me continue this discussion with some of my observations on specific asset prices. First, let me say that the phrase, My portfolio is more diversified and more liquid than I thought it was, is attributable to no one ever. It's always the case that investors find themselves too large and overly concentrated during a meaningful risk-off event.

[00:16:18] Of all the market prices I've seen as unsustainable, it's been the level of realized correlation among stocks in the S&P. Incredibly, this measure was 12 for all of 2024. The amount of dampening that this never-seen-before level has exerted on index volatility is hard to understate. Two things matter here. First, investors respond to what they see and experience via market prices.

[00:16:44] With correlations so low, portfolio moves of any real magnitude have been few and far between. Take Deep Seek Monday, Jan 27th, for example. NVIDIA plummeted by 17%, but the S&P fell by only 1.5%, as Apple actually rose by 3% that day. Thus, portfolios are sized taking this offset into account, with investors banking the diversification benefit as if it will always be there.

[00:17:13] As recently as mid-February, one-month realized correlation on the S&P was 2%. Today's reading, 51%, the highest since late 2022. The same forces, financial, monetary, economic, and geopolitical, that make stocks more volatile also make them more correlated.

[00:17:33] The 10-day realized correlation between Apple and NVIDIA has surged to 81%, as their realized vols have spiked to 72% and 73%, respectively. True diversification is very difficult to achieve, as we saw in the joint drawdown in stock and bond prices in 2022. While it, too, has started to draw down, gold has been a standout source of diversification.

[00:17:58] It's certainly not a hedge you can rely on, and gold will buckle as well should the vol experience so far lead to cascading asset prices, a soaring dollar, and a rush to raise cash. I've described the three different kinds of risk-off, which I call classic, taper, and liquidation. The last of these, experienced during a terrifying stretch in March of 2020, is by far the worst, and no asset except vol itself can survive.

[00:18:26] But gold does very well in the classic risk-off when stocks and rates fall together as a function of growth concerns. I like to say that you can learn a lot about an asset by simply observing how it does on the worst days for the S&P. When we run gold through this exercise, it shines. There are 39 down 4% or more days in the S&P since 2008. Gold's average return on those days is positive 30 basis points.

[00:18:52] Its correlation to the S&P on those days is just 22%. It's unrelated to the S&P when you need it to be, except, as I outlined, during a true market liquidation when both the stock and bond market crash together. Let's put our vol nerd caps on, shall we, and talk about the S&P vol term structure. This maps the implied vol by expiration and will reliably invert when a shock higher in realized vol on the S&P occurs.

[00:19:23] Backwardations, as some refer to the circumstance when shorter-dated implied vol is higher than out months, are rare and fleeting. For example, UX1, the front VIX future, is greater than UX2, the second-month VIX future, only 16% of the days since VIX futures began in 2004. Your longest periods of inversion are going to be SEP to DSO8, AUG to NOV11, and FEB to May 2020, with one day in contango in there.

[00:19:53] Term structure inversions are always related to the level of implied vol as well. It's rare, but not impossible, that a term structure inverts at a very low level of the VIX. The typical sequencing goes as follows. Markets digest new and unwelcome news. Realized vol gets shocked higher. As I mentioned, 10-day S&P realized was 17 and shot up to 47 two days later.

[00:20:18] This causes the most gamma-intensive options to surge in demand because they are most reactive to spikes in realized volatility. Those are the shortest dated options. Every other part of the term structure lifts as well, but with declining beta to that realized vol surge. Next, let's touch briefly on inflation and real rate curves. The market is fast repricing both the real and inflation component of nominal yields as well as the curves for each.

[00:20:47] For example, nominal two-year yields are down 72 bps in 2025, even as break-even inflation is actually up 70 basis points. This leaves real rates 142 basis points lower. And the break-even curve has, as it did in 2022, inverted again, with twos 108 basis points north of tens in break-evens. By contrast, the real rate curve is upward sloping by 145 basis points.

[00:21:16] This is an ugly mix. And it speaks to the real challenges that the Fed will have in executing on the dual mandate that is always in conflict, but now especially so, set against a backdrop of declining growth but potentially a higher short-term inflation environment. One asset pair that has experienced a pretty disparate relative move over the past couple of days is crude, down 13.6%, and one-year break-even inflation, which is unchanged.

[00:21:44] This speaks to the market jointly discounting a declining growth but firm inflation. In his speech Friday, Powell said that the Fed faces, quote, elevated risks of both higher unemployment and higher inflation. And finally, a few observations on how the market prices corporate uncertainty. One of the risk metrics that has proven generally impervious to risk-off episodes, like August 5th and December 18th of last year, has been credit spreads.

[00:22:12] I published a chart in mid-February showing that both credit spreads and credit implied vol were mired jointly in zeroth percentiles. The idea was that credit hedges really stood out from a value standpoint and that should the markets start to price real economy risk with just incremental probability, these could work. That's exactly what has happened with both metrics now in 90-plus percentiles. There's a great index calculated by Bloomberg called Global Trade Policy Uncertainty.

[00:22:42] The ticker is a doozy. B-B-U-N-T-P-G-D. B-BUNT-P-G-D. Which explains why credit is now enveloped in this risk-off. The degree of global trade uncertainty is literally off the charts. Today's level makes the trade, quote, war of 2018 to 2019 look like a shouting match at best. While we've seen a large move in credit spreads in a short period of time,

[00:23:09] history tells us that further concerns around growth leave more room for credit spreads to widen from here. Stepping back, the VIX has spiked more on a relative basis than credit spreads have, but that's mostly a function of the giant successive moves lower in the S&P and how that impacts a short-dated option measure like the VIX. If we compare the CDX IG to one-year S&P vol, it's a much closer historical relationship. Well, I've given you all I got for now.

[00:23:38] It's going to be quite an interesting week, and I hope we can continue to figure this stuff out together. Thanks for being a listener. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend. And before we leave, I wanted to invite you to drop us some feedback. As we aim to utilize these conversations to contribute to the investment community's understanding of risk, your input is valuable and provides direction on where we should focus. Please email us at feedback at alphaexchangepodcast.com.

[00:24:09] Thanks again, and catch you next time.