Should investors take advantage of the low VIX ahead of FOMC? Should investors take advantage of the low VIX ahead of FOMC? Should investors take advantage of the low VIX ahead of FOMC?

Should investors take advantage of the low VIX ahead of FOMC?

Equities 5 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  In today's equity note we take a look at the low VIX Index and the recent substantial drop in the index to see what historical patterns in the S&P 500 suggest about the future. Historically the current setup has lead to S&P 500 future returns over 3-month and 6-month horizons that are lower than normal equity returns and also with a higher risk of larger losses. Combining this insight with the economic setup and the pricing the Fed's policy rate in the future we take a look at whether put options might make sense for protecting the downside risks to equities.


The potential downside risk to equities

Ahead of the FOMC rate decision tomorrow it is worth going into the helicopter to try to understand the bigger picture. Our Head of FX Strategy John H. Hardy has written his ideas about the FOMC here. If we start with the market pricing of the FOMC then the current pricing suggest that the policy rate is hiked by 25 basis points tomorrow and then starting cutting again in November as the market is betting on recessionary like conditions will warrant the Fed to cut rates this year. But what if inflation and the nominal economy is more sticky?

Today’s Eurozone core inflation figures for April are suggesting that inflation is more structural and will only gradually come down. Take a look at the 3-month average Chicago Fed National Activity Index (the widest coincident indicator on the US economy). This index is back to zero, indicating trend growth, bouncing back from some of the weakest activity levels observed since 2009 back in December. Financial conditions remain below the historical average relative to the strength of the economy and have trended lower in the past weeks. The initial big reset of the Fed’s policy path this year happened during the Silicon Valley Bank failure, but as time has gone by, it is clear that we are not facing a global systemic banking crisis but something that is more idiosyncratic and manageable. Add to this, that China has just said it will do more to stimulate, and we have Europe that will be forced to stimulate from the government side due to the war in Ukraine. Taking all these facts into account, the market may be wrong on the Fed and economy and that is the key downside risk to equities. Tomorrow we will know whether these concerns are justified or not.

If take a look at put options on the S&P 500 then the low implied volatility makes downside protection decently priced and especially if the market is mispricing the Fed and the economy over the coming months. Put options with expiry on 18 Aug and strike at 4,165 are trading around 129 which corresponds to around 3.1% premium. This premium should be hold up against that the S&P 500 is up 8.2% this year and the previous moves we have seen when inflation has negatively surprised or the Fed’s policy path has been dramatically changed. For the investor that has already got the market return or more, protecting the downside risk here could make sense as the market may have exhausted itself on the expected policy easing post the mini banking crisis.

S&P 500 Index | Source: Saxo

What does the VIX Index tells us about the future?

The VIX Index is currently trading around 16.6 down around 10 index points over the past 35 trading sessions. This level is quite below the long-term average around 20 and suggests that the options market is rather calm going into tomorrow’s FOMC rate decision. As we have outlined above, the market might not be accurately pricing the risk that the Fed once and for all tells the market that inflation is more structural and thus the policy rate will not be lowered this year. Regardless of the FOMC’s wording tomorrow on the policy outlook, we can always take the current setup and go back in time and see how the market reacted.

If look back as far as 1 Jan 1990 then there has been 78 cases when the VIX Index has been below 17 and dropped more than 8 index points in just 30 trading days. Measured on future returns across horizons of 1-week, 1-month, 3-month, and 6-month, then the S&P 500 Index is up on average across all horizons. This is not surprising given equities have a positive drift. But what if we subtract the drift? In this case the 3-month and 6-month horizons show significant underperformance relative to the normal drift with a statistical significance level of 0.5%. On the 3-month horizon the S&P 500 does 2%-point worse than the normal 3-month performance in S&P 500 when we have a compressed VIX Index below 17 and with a substantial recent negative change. Another way of looking at this is that the 25%-percentile on all 3-month future return samples is -0.0079% (so in 25% of the time the S&P 500 has a negative return of 0.0079% or worse) compared to -3.77% when we have the current VIX setup. These historical patterns can help inform the investor of the risk-reward ratio related to buying put options as discussed in the beginning.

Others have also previously been writing about the VIX level combined with changes in the index itself and have come to the same conclusions, namely that there are no strong one-dimensional signals in the VIX. It can add some information to the decision making process but cannot be the sole answer.

VIX Index weekly prices | Source: Bloomberg
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.