Tail Risk Terrors Send Volatility Soaring, But...

Authored by Simon White, Bloomberg macro strategist,

The VIX is rising against the volatility of at-the-money options - i.e. those whose expiry is close to where the S&P is currently trading - as the price of upside and downside protection adjusts to evolving risks from the Federal Reserve and geopolitics.

The VIX has been preternaturally low versus almost everything else - from cross-asset vol to realized volatility - for some time.

The index was also low versus at-the-money volatility, but that too is changing.

The VIX, as a reminder, is a weighted average of almost all puts and calls on the S&P 500 with around a one-month expiry. When it was low versus at-the-money volatility it meant the tails were relatively cheap. This was especially influenced by the (carefree) lack of demand for downside protection.

But risks are being reassessed. The rates market has priced in plenty of insurance, with about 185 bps of Fed cuts priced in by end of next year. In this cycle, the more interest-rate cuts that have been priced, the lower put skew has been, inferring that demand for downside equity protection was less when there was plenty of easing priced – this is the Fed put in action.

But now that dynamic looks to have changed, with put skew rising over the last year or two even as deep rate cuts have been priced in.

Out-of-the-money put skew has been rising in recent weeks as tensions in the Middle East have heightened, but given equity investors now look to be less cavalier on risks in general, they are perhaps more likely to start protecting their downside with greater alacrity.

That means the VIX is likely to remain supported. But contrary to most of the last two decades, that does not mean stocks need fall. A superabundance of liquidity and stretched valuations means that stocks and the VIX are set to rise together, as they did in the 1990s.