As we first showed last week, while the equity market has remained completely oblivious to what the upcoming debt ceiling fight, which Morgan Stanley admitted over the weekend "worries us most" of all upcoming catalysts, the same can not be said of the T-Bill market, where 3M-6M yields have inverted the most on record on concerns about a potential selloff (or worse) in 3M bills which mature just after the time the US Tsy is expected to run out of cash, should the debt ceiling debate fail to result in a satisfactory outcome.
And while it is a gamble to suggest that stocks will ever again respond to any negative news or still have any capacity to discount any future event or outcome, Bank of America dares to go there, and advises clients that between seasonality, and the already record low VIX, the debt ceiling is a sufficiently risky event to expect that equity volatility will finally wake up, and that "seasonality + catalysts suggest record low vol likely unsustainable through the fall." Here's the big picture from Nitin Saksena and team:
While VIX has been making headlines for the most consecutive closes in history below 10 (now 8 days), medium-term VIX futures have quietly fallen to ~10-year lows, breaking the previous record from summer 2014. However, we think volatility is unlikely to sustain these extreme lows in the fall and like selling Oct VIX puts as (i) seasonal patterns suggest the VIX troughs in Jul and peaks in Sep/Oct, (ii) the VIX has “settled” below 12 in only two of the past 27 Octobers, and (iii) fundamentally, the threat of debt ceiling brinkmanship in Sep/Oct, which has already spooked the T-bill market, should help support equity volatility. For example, we like selling the VIX Oct 12 put vs. the 14/19 call spread for zero-cost upfront (Oct futures ref 13.35).
Taking these one at a time, first we focus on the seasonal aspect. What is most interesting here, is that not once has the VIX settled below 10.5 in either September or October.
Statistically, seasonal trends in the VIX (Chart 10) suggest that July is the low point in the calendar year, with implied volatility subsequently rising and peaking in Sep or Oct depending on whether the 2008 crisis is excluded or included. Put slightly differently, as seen from Chart 11, VIX “settlement” in the months of Sep and Oct has exceeded 10.5 every time since 1990 and has been above 12 92% of the time (50 out of 54 instances). That said, three of these four “prints” below 12 occurred in Oct-93, Sep-06, and Oct-06, periods reminiscent of today’s record-setting low vol. Hence, understanding potential fundamental tailwinds to volatility this fall is also critical.
And then there are the event catalysts, of which the debt ceiling is by far the biggest:
Fundamentally, a number of catalysts are on the calendar from late Aug through Oct this year (see Table 2), including (i) the potential for Jackson Hole and Sep/Oct central bank policy meetings to rekindle the “policy tightening into a slowing backdrop” narrative, (ii) the potential for brinkmanship around US tax reform, and (iii) following the end of FY2017 on 30-Sep, the potential for a debt ceiling crisis and US government default.
Rates strategist Mark Cabana notes that the Treasury bill curve has inverted dramatically recently on debt limit concerns (Chart 12) and is pricing in stress much earlier than in prior episodes. This is important for equity investors to watch as T-bills are much closer to the potential source of risk, hence could be a leading indicator for equities. Although the spike in US equity vol was much more pronounced in the 2011 debt ceiling crisis compared with 2013 (Chart 13), in both cases the relevant VIX futures remained supported leading up to the potential default dates.
So for those who agree that - finally - VIX is about to jump, whether due to the debt ceiling debate turning ugly, or because any of the other listed catalysts turn out less than favorably, yet want to express a more convex bet than merely shorting Bills, here is how to do it, again from BofA:
Trade idea: VIX Oct 12/14/19 call spread collar for zero-cost upfront
To be clear, we are not calling here for a structural shift from low to high US equity vol this fall. Such a regime shift would require some combination of higher rates, more inflation, a weakened Fed put, and less aggressive equity dip-buying. Rather, we are suggesting that the above combination of statistical and fundamental factors make it highly unlikely that today’s extreme lows in VIX can persist through the fall.
As such, we are comfortable selling VIX puts to leverage a likely floor in volatility, particularly ahead of the debt ceiling, and using the premium collected to the cheapen the cost of portfolio protection. For example, investors may consider selling the VIX Oct 12 put vs. the 14/19 call spread, indicatively zero-cost upfront with a net delta of +54 (Oct fut ref 13.35).
The trade leverages the facts that (i) VIX 3M ATMf implied volatility, while low, is not necessarily cheap compared to the level of the VIX 3M future (Chart 14), and (ii) VIX 3M call skew is currently very steep, in the 92nd percentile since Sep-09 (Chart 15).
More critically, while VIX call spread collars have been challenged by recent sub-11 VIX settlement values, they can be successful, low-cost hedges when there are defined macro catalysts on the calendar to provide support to volatility, as seen from the US election and more recently the first round of the French election. Lastly, we are comfortable capping upside via the call spread as the VIX 1M and 2M futures have not closed above 20 since Brexit over one year ago.
As one estimate of potential carry costs for the structure, we note that the same structure in September currently costs $0.40 to initiate (ref 12.55) and in August costs $1.15 to initiate (ref 11.25). The former may be a reasonable estimate for decay over the next month should markets remain quiet during the summer. However, the latter ($1.15 over two months, or $0.575 per month) is likely too high, in our view, as it assumes the Oct future will fully roll down the curve to 11.25 roughly 3-4 weeks ahead of Oct expiry, when debt limit issues may well be taking centre stage.