VIX index points to major risk event

Macro 5 minutes to read

Steen Jakobsen

Chief Investment Officer

Summary:  This is getting serious. Very, very serious: the VIX fear gauge is flagging a huge risk event on Friday – the China-US trade deal cliffhanger. Our Saxo Strats view the outlook as binary: 5% to 10% to the upside should a diplomatic thaw occur, but perhaps a 25% plus correction if the talks end in acrimony.

ACTION: Increase in RISK ALERTNESS across our organisation and customers due to big event risk Friday (from midnight Eastern Time, that is 6:00 AM CET Friday) and massive ILLIQUIDITY in volatility.

COMMENT: This is a “separate” and “standalone” exercise vis-à-vis a breakdown in trade talks between the US and China as liquidity, or rather,  illiquidity, is behind all major market selloffs in history and this weekend has the biggest short position in volatility ever

Saxo Strats view: This is now a binary outlook – 

1. Either we get a diplomatic “softening” and a 5-10% upside 
2. or this could accelerate into a > 25% correction 

OVERALL this matches our “False Stabilisation” macro theme, where we argue the transitory impact from the lower price of money is just that, a "blip” in the downtrend in economic activity and credit facilitation which we expect to bottom by August……

We still see 75% chance of “some diplomatic agreement”, but the 25% tail-risk is now in play due to the “illiquidity constraints” illustrated below.

This first chart is from Marko Kolanovic @ JPMorgan and shows the relationship between VIX vol and liquidity. The relationship declines exponentially with the rise in VIX.

We have exceeded 22.50% in VOL just ahead of the New York open today…

The red arrows (done by me) show how we have moved from a rich liquidity of 6-8 K contracts to less than 2K…… VIX rises, so does illiquidity.

The end risk here is – and its always the case in market crisis – that the market runs out of liquidity in this case in derivatives, not something the Federal Reserve can directly impact. (In this respect it mirrors the 2008/09 crisis where CDO, SPV became illiquid and created massive losses).

Chart illustrating the big RISK of ILLIQUIDITY 
The added risk here being the market is in biggest short position – EVER.

This from Ole S Hansen and his Commitmment of Traders report……

At the current price level most of the record short is under water:

As of yesterday the open interest has only fallen by 4% since April 30 => plenty more to come

Finally, here is an important run through of the dynamic hedging risk from:

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