Lee Hong Wei
Singapore Sales Trader
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.
Studies have shown that while there is no clear predictive power of the shape of the VIX curve to the forward looking equity market, the VIX market can be in a sustained period of backwardation and that was seen in the 2008 correction which we saw the term structure in a continued period of backwardation for close to 70 trading days. The recent correction in the the fourth quarter of 2018 also saw a similar period of sustained backwardation in the VIX curve which puts off equity bulls. In the current risk-off scenario now, I think investors should remain vigilant about the development in trade wars as a sustained period of low volatility (such as in 2017) is unlikely to be seen given the current global backdrop and geopolitical risk scenario.