Realised and implied volatility in credit and equity markets had been close to all-time lows in both the US and Europe in recent weeks. But a slump in corporate bonds, in concert with a disappointing European Central Bank statement and speculation about a US rate hike, was the catalyst for a marked rise in US and European volatility that began last Friday and continued into the early part of this week. Having sustained near-historic low levels of below 12 for several weeks, the CBOE VIX leapt to higher than 20 on Monday
That short rumble has caused a bout of nervousness ahead of next week, when the US Federal Reserve and Bank of Japan both meet just as credit derivatives indices roll into new series – typically a time of heightened activity in the market.
“This spike in volatility happened out of such an incredibly calm period,” said one equity derivatives official at a bank in London. “We had the highest range for the S&P index in 50 years and realised volatility was at its lowest point since the mid 80s. It really didn’t take a large move in bond markets to wake people up again.”
A key source of concern is that buyside market participants have been rolling out of short-dated September and October volatility hedges in equity and credit, leaving them exposed to any sudden moves. Instead they have preferred to focus on expiries in November and particularly December, where they see the most potential for market upset.
“There really aren’t a lot of obvious catalysts for volatility in October,” said a credit derivatives official at another bank in London. “So people have been looking beyond that to more obvious drivers such as the US elections in November and the Italian referendum at the end of that month. The market is also inclined to believe that any Fed rate rise will happen in December rather than sooner.”
But any complacency about near-term exposures could be immediately tested and found wanting next week, if either the Fed or BoJ meetings produce a surprise.
“People are still complacent about this, but the past week it has felt like the wind is changing and I’m getting nervous,” said the credit derivatives official. “The market is only pricing in an 18% chance of the Fed moving on rates next week, when only a week ago it was much higher. If they do announce a hike it could be quite painful, even in emerging markets. Stocks are still high and you would expect more volatility there. And volatility quotas are still really low against historical levels.”
One mitigating factor is that the market’s recent big long position in iTraxx Europe has come back off its near historic level as a result of this week’s volatility, with some $800m reduced exposure. But this could also be because market participants are preparing for the index roll into series 26 next week.
“Longs tend to roll quickly into the new index, but shorts take their time,” said one credit derivatives strategist. “Senior Financials is the only index where there is a net short position, and that has been reduced this week. In CDX IG the buyside has increased its long position, so the market really isn’t prepared for any shocks. It could be very messy if this goes the wrong way into the roll.”
