With the drop in stock prices over the last few days, equity markets have fallen and the VIX index – a measure of volatility implied by short-term options on S&P 500 stocks – has surged, as it typically does when the market drops. Last night we discussed the situation in our daily post-market note, The Closer. As shown in the chart below, this is the third time the VIX has surged over the last 18 months, with the first being a huge uptick relative to a more modest equity price decline than the huge drop in Q4. That first spike was driven by a collapse of products designed to profit from low or falling volatility.

Similar to the last drop, speculators in volatility futures have built up large short positions in volatility recently. Of the outstanding open interest in VIX-linked futures, about 40% is net short exposure for traders classified as speculators in the CFTC’s Commitment of Traders report. Are we due for another stratospheric move in the VIX as weak hands are shaken out of VIX future shorts?

While a further rise in implied volatility isn’t something we can rule out, this time does look pretty different from the early 2018 volatility market blow-up. First of all, exchange traded products (ETPs) that are exposed to the VIX are very long volatility. In 2017, a huge short position had built up via these ETPs, with a VIX short market cap of almost $4bn. At the time, long volatility ETPs had a combined market cap of less than $1bn. Now, the market cap imbalance is completely reversed: short vol products have only about $500mm in market cap while long vol products are north of $3.5bn. So retail traders – the primary customer base for this type of product – are positioned in the opposite manner. Furthermore, total VIX futures exposure has fallen dramatically. Back in September of 2017, there were more than 704,000 VIX futures open, with more than 650,000 outstanding in mid-January of 2018. Today, that number is 36% below the peak and 31% below where things stood in January of 2018. So not only are retail traders positioned the opposite way, total market size and therefore exposure to the VIX has dropped considerably.  Start a two-week free trial to Bespoke Institutional to access The Closer and all of our other market analysis.

Heading into last week’s FOMC meeting, futures markets were pricing in close to an 80% chance of at least one rate cut from the FOMC between now and the January 2020 meeting in less than eight months.  In his press conference following that meeting, Fed Chairman Jay Powell did his best to reset market expectations by arguing that recent low inflation readings are transitory and by saying that the FOMC wasn’t currently leaning in one direction or the other with respect to its next move on rates.

The result of Powell’s non-dovish remarks (but definitely not hawkish either) was a relatively sharp reversal in equity prices and a re-pricing in the futures markets regarding the likelihood of rate cuts between now and January.  By last Friday, the market was only pricing in a slightly better than 50-50 chance of a rate cut by the January 2020 meeting.

In the span of the last three trading days (and a Sunday tweetstorm from the President regarding China), though, traders in Fed Funds futures are once again back to pressing their bets on the possibility of rate cuts.  As of this morning, those odds have moved back up to 66%.

Recent moves in the yield curve are also starting to suggest that the FOMC may have to blink.  After a brief inversion in late March, the yield curve, which we measure as the spread between the yields on the 10-year and 3-month treasuries, started to steepen again in April, which likely caused a sigh of relief in the halls of the Federal Reserve.  Over the last few days, though, the flattening trend has returned with vigor and as of this morning is just one basis point from inversion again. If that happens, there’s a good chance that it won’t sit well with markets.Start a two-week free trial to Bespoke Institutional to access all of our market, earnings, economic, and FOMC analysis.