Long-Dated VIX Still Priced For Depression Risk

Since the spike in VIX in October of last year, short-dated volatility (and correlation) has dropped significantly, but the vol term-structure has steepened, and long-dated volatility remains stubbornly high. Goldman Sachs updates their volatility debt cycle thesis today and so far we are following the typical cycle post-volatility-spike - realized vols drop, short-term implied vols drop, term structure steepens, long-term vols drop - leaving them focused on both the implications of the current low levels of short-term vol and the high-levels of long-term vol. In brief, short-term volatility reflects very closely the current macro environment (GDP growth, ISM, high-yield, and Goldman's models) but longer-dated volatility trades significantly worse. The front of the volatility curve is in-line with the economics, the back is still pricing in potential damage. The volatility (variance swaps) market is expecting realized volatility to be very high over the next 5-10 years - the only time this has happened was during The Great Depression.

 

 

The four-stage model of post vol spike market behavior is very useful (if not somewhat obvious) in considering where we are in terms of sentiment.

Stage 1 has clearly evolved as 1m S&P 500 realized vol has dropped to 10, 20% of its peak level of 50 in Aug-11. Interestingly, 1m realized correlation has also dropped notably during that period from 0.83 in 2011 to 0.23 currently.

Stage 2 has occurred as VIX (implied vol) has tracked realized vol lower (but at a significant lag admittedly). The spread between VIX and 1m realized vol is currently 8 vols - almost double its 20 year average (no wonder its so attractive to keep selling that premium).

The steepening in the vol term structure that we have been discussing recently is Stage 3 and at 7 vol points (12m - 1m term structure), its almost 20x the 20-year average of only 1 vol point (again for the stat arbs, it would seem vol flatteners were 'cheap') but as Goldman points out, the current macro environment (modeled by GDP growth, ISM, high-yield, and other models) is priced in, realized should be around 14, and VIX around 18-20 - or where it is now.

So that leaves Stage 4. This is the evolution back to normality of the longer-dated volatility market. This has not happened.Long-dated variance swap markets are priced to expect very significant realized vol - on a scale with those exhibited during the Great Depression.

 

It is clear that the overhang of the realization that the impossible is possible (post US downgrade and then Greek PSI) leaves professionals willing to bid for longer-dated macro (vol) protection.

Professionals remain anxiously aware that the global debt super-cycle has ended and that we face deleveraging and deflationary pressures for years to come, short-dated vol will continue to ebb and flow with each band-aid and risk flare but investors deep-down know that the 'big one' remains around the corner.

As Jim Reid noted this morning in his macro strategy:

Indeed Debt/GDP ratios across the Western World are in many places still growing, especially in the public sector. So sluggish growth and high debts across the whole of the Western World leave us more vulnerable to shocks for a long period ahead. Although markets are in a healthy state at the moment it would only take a relatively mild cross-wind to expose the problems again. We desperately need decent growth across the Developed World in order to reduce the fragility of the system.