Last July, Morgan Stanley’s Chris Metli, executive director of the bank’s institutional equity division, wrote an article – posted here – looking at what would happen “if the VIX goes bananas” which previewed yesterday’s results with eerie accuracy.
And, a little over six months later, the VIX did finally go bananas. Here is Metli’s Post Mortem of what happened.
by Chris Metli of Morgan Stanley
With a 4% drop in cash equities and even greater decline in futures, the VIX finally went bananas rising 20 points to the highest level since Aug 2015, and the weighted average 1-month VIX futures rose 96%. This creates more supply from systematic funds for the rest of the week and nearly bankrupted the inverse VIX ETPs with NAVs down 96%. To summarize the price action and implications:
- Some of the selling on Monday likely reflected investors anticipating systematic supply on Tuesday – this means the $30 to $35bn QDS estimates for sale Tuesday (detailed below) may net down to $15 to $25bn. This is still enough to have negative impact on markets though and will be compounded by dealer short gamma positions.
- Anticipation of further supply later in the week from both annuities and risk parity funds could bring in more fast money sellers Tuesday.
- The near bankruptcy of the inverse VIX ETPs will be a very negative headline, and the several billion dollar loss for holders, largely retail, will scare some out of the market or force liquidations of other products to raise cash.
- Institutional vol sellers will likely cover exposures as well in the coming days and weeks. While these positions will not take losses on the same scale of the VIX ETPs (because they are generally scaled more conservatively) unless there is a quick snap back many investors will likely take down risk, supporting implied volatility in the process.
- On the positive side, much of the short gamma exposure in the VIX market has been wiped out, leaving less risk of a further volatility spike from here.
- Investors were not in panic mode despite the selloff, as this move has ‘only’ wiped out one month of P/L. As noted earlier in one sense this is good as it might slow discretionary supply, but it also highlights that discretionary investors are still very long risk and could easily turn sellers.
- Who are the incremental buyers here? Macro funds betting on the vol unwind that has now happened could cover and turn buyers, but for real support the market needs deep pocket asset allocators to step in. Vol target supply will eventually wane as volatility peaks and/or leverage comes down, but they likely remain sellers for the next several days.
- Net-net: more supply likely pushes markets lower Tuesday and potentially Wednesday, and buyers will need to see signs of slowing supply and stabilization to come back in. Short-dated implied volatility has likely peaked, while the back end of the vol curve likely rises over the next week and realized volatility will continue to move higher. This is unlikely the turn of the cycle as the selloff is largely technical and positioning driven, and likely not large enough to feed back into the real economy and become fundamental, so dips will be bought after the systematic supply and vol unwinds abate.
QDS came into Monday expecting nearly $5 to $10bn of equity supply from systematic funds, principally annuities as they tend to react quickest to recent increases in realized volatility. That supply likely contributed to the move lower, but it was then compounded by dealers having to hedge their short gamma exposures. QDS estimates that in total dealers likely had to sell $11bn of S&P 500 futures on the way down today.
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