What if the Fed surprised today, and instead of only announcing a reduction in its balance sheet, it also sent an uber-hawkish signal by hiking rates 25 bps, something which virtually nobody expected? While stocks would certainly suffer an adverse reaction, as the Fed confirmed that its intention was to burst one or more asset bubbles, it may be just what many in the market desire.
The reason for that is the active trader community has been growing increasingly bearish in recent weeks, and in anticipation of a potential downside shock as stocks trade at all time highs, it has been aggressively putting on hedges. One place where this is visible is in S&P 500 options where the put to call ratio has climbed to its highest level in more than two years according to Bloomberg.
A second place where bearish bets have been piling up is among the mega-cap tech leaders of this rally. As the Nasdaq soared above 6,000, demand for downside rose grew to the most in over a year on the most popular tech ETF, the QQQs.
A third place which as we demonstrated yesterday has seen a significant increase in "fat tail" insurance, is the VIX itself, where the term structure has steepened to the most since February as traders increasingly buy longer-protection.
And yet all these hedges may be overriden by one other disturbing observation made overnight by Bank of America, namely that the gross vega outstanding in levered and inverse VIX ETPs has reached $375mn vega, an all-time, and surging by 50% just in September alone! BofA's Benjamin Bowler explains:
Levered long vol VIX ETP positioning up 50% MTD, short remains at record high Implied vol continues to remain near historic lows and investors have begun to enter the levered-long vol trade on the expectation that today’s quiet will not persist through the catalyst-rich fall. Open interest in levered-long VIX ETPs (TVIX and UVXY) has more than doubled since mid-August and now stands at $150mn vega (up 50% month-to-date).
Since the beginning of September, unlevered long positioning has remained relatively stable, while inverse positioning picked up slightly MTD to $225mn vega and is at a fresh all-time high. Together, the outstanding vega of both levered and inverse VIX ETPs has climbed to a staggering $375mn vega, an all-time high as well.
As a reminder vega is simply a measure of the sensitivity to each percentage point change in vol, for the total universe of VIX related ETFs adjusted by their short interest. As vega has never been higher, it means that a sharp move higher in VIX would result in disproportionate move in underlying VIX-tracking ETFs, which in turn could roil a market which has shown a substantial correlation to vol indices as vol shorts scramble to cover.
BofA concludes that "a volatility spike would cause both sets of ETPs to trade in the same direction in order to reset their leverage" and adds "that this is a historically large amount of vega to trade."
In short, it means an eruption of market chaos.
Indicatively, a similar analysis conducted by Morgan Stanley just over a month ago, calculated that should the S&P fall 3.5%, "first, the VIX could rise as much as 12 points. When volatility is low it tends to move a lot for a given change in the S&P 500. That effect is likely to be exacerbated now because a) skew is steep (and VIX rolls up the skew in a selloff) and b) many players in the VIX market are short. Taking these dynamics into account QDS estimates VIX could rise ~12 points for a 3.5% 1-day decline in SPX."
With the vega even higher now, it would take an smaller move in the S&P to literally blow up the VIX.
We may very soon find out just how resilient to exogenous, Fed-created shocks this market truly is.