The equity market has since retreated 5% from its peak in May and the VIX index, aka the fear gauge, has soared massively since then. The VIX tracks the 30-day implied volatility of S&P500 options. The VIX curve has moved to backwardation after renewed trade tensions between China and the US last week, but it has been undisturbed for a good four months since early January after the Federal Reserve chairman Jerome Powell said that the Fed can be “patient and flexible” regarding interest rate adjustments.
The dovishness on the part of the Fed was sufficient to help a then free-falling market back to the recovery zone. Since then, the equity market was also supported by multiple rounds of trade talks and negotiations, while improving economic data from China also provided a second wind to propel the equity market higher.
But what exactly is backwardation and why is it important? The term covers a situation in which the spot or near-term price of the underlying instrument (in this case the VIX) is higher than the forward price. This gives the chart a downwards sloping curve and structure. This phenomenon was witnessed last week after the trade war escalation between China and the US and implies that market participants are expecting much more volatility in the near term.
In a “normal” market condition when the equity market grinds higher or trades sideways with no near-term shocks foreseen, we expect a time premium to be paid for the longer-dated futures and the term structure to be in upwards sloping, a situation known as contango. Should this be the case, traders and market participants are expecting or betting the S&P500 index will fall.