Will The Market Shock Escalate Further: It Depends On Just One Thing

The great, and record VIX eruption of February 5 may have come and gone - or is at least dormant for now in the aftermath of the great VIX ETP extinction event - but that does not mean it won't come back: in fact as Goldman's new head quant wrote overnight, the bank's clients had just one recurring question in recent days: "do i have to worry about another volatility spike."

While Goldman answered in the context of the vol complex, where things have certainly eased down substantially since the record Vega prints from last week...

... there is another, potentially far more violent storm brewing, and it has little to do with equities.

In a note from BofA's X-asset hedging team published overnight, the bank's strategist Jason Galazidis writes that while the muted cross-asset risk shows the equity shock was largely technical, there is one indicator that may confirm it is not only returning, but is set to spread to all asset classes.

Here is BofA's framing of the narrative that has been on everyone's lips for the past two days.

The sell-off in global equities and in particular US large-caps precipitated an unprecedented jump in S&P implied vol. Notably, the 8% decline in the S&P from late Jan to 6-Feb has already registered as the 10th largest drawdown since 2006. As an indication of how concentrated the shock was to US large caps, S&P puts were by far the best performer and are now the most expensive hedge across the 34 assets in our screen (Chart 1). We would not expect this to persist as markets calm.

To be sure, cross asset vols and credit spreads have not been immune to the repricing of equity risk, but as we pointed out over the past few days, these reactions have so far been less severe: meanwhile, global equity volatility is currently well above long-term median levels for the first time since the Nov-16 US elections.

In contrast, BofA notes, other broad asset risk measures are comfortably below median with commodity, rates and credit actually hovering near their 1st decile since May-07.

In other words, contagion has thus far been relatively limited, again pointing to a technically driven shock which is likely to fade absent cross asset spillover.

Which brings us to the punchline: with the great equity volquake come and - for now - gone, what one indicator should traders watch to determine if a new market shock is imminent? Here is Bank of America's answer:

We continue to believe that watching rates vol is particularly important to gauge the potential for this to escalate further.

If BofA is right, this may be a problem, because as the following chart of X-asset vols for all 4 main asset classes (Equities, rates, FX and commodities) shows, while equity vol is declining, rates vol is creeping steadily higher.