Equity market volatility reminds us of the old saw “Everybody talks about the weather, but nobody does anything about it.” For example, the CBOE VIX Index, aka the “Fear Gauge”, is a regular topic of conversation even though very few market participants actually trade S&P index options. As we’ll discuss in a moment, the only thing that really matters is if the VIX is trending higher or lower; whether the VIX is 10 or 30 is largely irrelevant in terms of making money in stocks.
There is, of course, one entity that can “do something” about the VIX – the US Federal Reserve – and history shows it does so when volatility ramps quickly higher due to a systematic shock. That’s the “Fed put”, born out of Alan Greenspan’s rallying the troops after the October 1987 crash and still in place today.
But what happens when the Federal Reserve starts to remove its accommodative policies? That’s the state of play today, with the market expecting a tapering of bond purchases later this year and a rate hike (or two) in 2022.
We will answer that question today with 3 points related to both how the VIX performs across cycles and specifically how it behaves during periods of monetary policy tightening. Rising volatility usually goes hand-in-hand with lower stock prices, so this analysis also serves as a guide to portfolio positioning.
#1: This chart shows the VIX Index’s long run cycles back to 1990, and it tells a very clear story about how macro and market uncertainty drives volatility. We’ve put arrows at the peaks and valleys to show how the VIX runs in multi-year cycles.
Here is the long run historical narrative we see in this picture:
- The right third of the chart (1990s) shows how the VIX dropped for 5 years after Gulf War I (1991) and then rose during the dot com bubble and all the way through Gulf War II (2003).
- It then fell again during the 2000s economic recovery and housing bubble, but rose quickly during the Financial Crisis.
- The 2010s saw the longest period of declining VIX levels and the longest period of sub-19 readings (VIX long run average), only starting to increase in 2018.
- The pandemic caused the last flare-up in the VIX, but it is already below the long run average (17 today).
Takeaway: the VIX measures investor uncertainty, so its direction is a function of whether the odds of a negative macro surprise are rising or falling and peaks only occur in the wake of a truly outsized shock. The VIX’s speedy decline from 2020 simply says that highly accommodative fiscal and monetary policy have lowered the probability of a near-term shock. A VIX at 17 versus a long run average of 19 fits that narrative as well.
#2: Will the VIX begin to rise (and potentially push stocks into a volatile sell off) when the Federal Reserve begins to taper its bond purchases?
- This chart shows the VIX (black line) and the annual percentage change in the size of the Fed’s balance sheet (red line) back to 2010. Three points here, fleshing out the notations in the chart itself:
- The VIX remained low (i.e., below 20) all the way from the May – July 2013 “Taper Tantrum” through the actual start of tapering in 2014.
- It was not until 2015 that we saw outsized volatility, and that was due to a market structure issue.
- S&P returns in both 2013 and 2014 were strong: +32.2 pct and +13.5 pct, respectively.
Takeaway: history shows that the Fed tapering its bond purchases does not fit the definition of a “surprise” to equity markets, so it does not inform equity market volatility in the same way true shocks do. While this is hardly a surprising observation, you won’t often find it in market commentary regarding the upcoming reduction of Fed bond buying even though the historical record is crystal clear on this point.
#3: Now, let’s look at how the VIX behaves when the Fed starts raising interest rates after a recession.
The following chart shows Fed Funds (red) and the VIX (black) since 1990 and notes the policy liftoffs in 1994, 2004, and 2016. In only one case – 1994 – did the Fed’s first rate move after a recession cause any incremental volatility. Readers with long memories will recall this was a 50-basis point move, and that was a legitimate surprise.
Takeaway: just as with tapering, the Fed’s first rate increase after a recession does not constitute a “surprise”. Yes, overtightening can absolutely create volatility. This happened in 2000 and 2018, for example. We are a long way from that at present.
Summing up with an anecdote. Back in the low volatility late-2010s we worked with a sell-side options trader who, when asked how his smart-money clients were positioned, would always sigh and say “Oh … They’re bracing for a modest pullback … buying a 15 VIX, hoping it goes to 18 …” Needless to say, this was not typically a successful trading strategy.
The current environment feels a lot like that, one where widely discussed catalysts for volatility – tapering and rates – simply don’t fit the bill as narratives which create actual uncertainty. That’s why we are more focused on issues like the health of the post-stimulus US consumer just now. Surprises – by definition – come from unexpected events, not ones that are widely telegraphed and discussed.