Deutsche: “The Last 36 Hours Are A Dress Rehearsal For When The Bear Market Hits”

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Some observations on recent market volatility, from Deitsche Bank’s credit strategist, Jim Reid.

If you’ve only been working in markets for a handful of years then treat the last 36 hours as a mild dress rehearsal for what can happen when a bear market hits. Yesterday actually felt relatively orderly though in spite of a 1,000 point  range on the DOW and a 28 point range in the VIX. Orderly unless you were at the epicentre of things and an equity volatility trader. I’m teaching 2 and a half year old Maisie how to count to five at the moment and the VIX yesterday felt like watching her do that as when I ask her to count for me she says something likes this “….four, two, three, one, five”. It closed at 37.32 the previous session before climbing to 50.30 around noon London time, then collapsing to 22.42 just after the US opened 2.5-3 hours later, a spike back to 46.34 occurred less than an hour later and then after oscillating between 30-40 for the rest of the day we closed at 29.98 (-19.7%). The 50.30 print was the highest since early March 2009 when equity markets hit rock bottom. Remarkable really.

Yesterday afternoon Craig and I put a note out showing what happens 1 week, 1 month and 3 months after the largest 10 VIX spikes in history. Basically the VIX usually rallies over all subsequent periods but equities tend to be strong the week after but on average fall 3 months later. The reverse is true for bonds. (See end of this post for details.)

What might make this VIX spike slightly different to previous ones is that although it had a macro catalyst (higher inflation and yields) the scale of the wounds are mostly self inflicted within the equity derivatives product as the scale of the moves have been caused by low volatility ETPs/ETFs being liquidated, suspended and/ or suffering major losses

In other words all the other previous major spikes have been more to do with a big macro event or a crisis. The higher average earnings print could turn 2018 into a year of higher inflation and a big macro shift but we’re certainly not in crisis territory yet.

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What happens after large VIX spikes

Monday’s 20 point jump in the VIX was the largest ever. In fact it is nearly 4 points more than the next biggest single day spike back in October 2008. So by magnitude this spike in volatility is somewhat unprecedented. For the purpose of this short note we have taken a look at how the VIX, S&P 500, Treasuries and Gold have responded in the 1 week, 1 month and 3 months following some of the largest spikes in the VIX ever recorded (excluding the moves this week).

Figure 1 show VIX moves over periods of 1 week, 1 month and 3 months following the 10 largest jumps in the VIX (excluding this week’s moves). As you can see, in essentially 9 out of the 10 previous cases, the VIX has subsequently fallen. Indeed the average decline in the VIX following a spike is 8.5, 9.2 and 19.1 points over 1 week, 1 month and 3 months respectively. Using the median, declines extend to 11.2, 12.7 and 20.4 points. Unsurprisingly a lot of these moves are bunched around the GFC years when large spikes were a lot more common but nonetheless with the exception of September 2008, these jumps to elevated levels were not sustained. Additionally, the VIX actually corrected to the point where by it was lower than the starting point (i.e. one day prior to the spike) in 4 out of the 10 occasions after just 1 week and 8 occasions after 3 months.

In terms of how assets have performed, figures 2 and 3 show the median VIX, S&P 500, 10y Treasury and Gold moves in the same time periods following these VIX spikes.

There is a fairly consistent theme coming through these charts. The initial short term reaction has been for markets to actually display a more risk-on tone with the median S&P 500 return being 3.9% in the week after (there’s only been two instances where the S&P 500 actually fell) while 10y Treasury yields have jumped 15bps and Gold has fallen a more modest 0.5%. However over the 1 month and 3 month time horizons, these moves have reversed. The median S&P 500 return in the 1 month and 3 months following a huge vol spike is -0.4% and -2.6% respectively. 10y Treasury yields have fallen 11bps and 42bps while the price of Gold has risen 7.5% and 3.5%.

Just for additional information, we’ve put together a scattergraph of all >5 point one-day VIX moves versus the subsequent VIX, S&P 500 and 10y Treasury moves to catch a larger sample size. In conclusion, VIX spikes do tend to be corrected over all periods out to the next 3 months but historically there is evidence that equities and bond yields have fallen over the subsequent 3 months.