The recent decline in equity markets has been significant: The S&P 500 fell as much as 8% over three sessions, before rebounding on Tuesday to close with a 1.7% gain. But the spike in implied volatility has been unprecedented. The VIX Index of S&P 500 option volatility jumped 20 points on 5 February to hit 37, a record single-day rise. On 6 February, in illiquid markets, it rose as high as 50, at which level the VIX was pricing the equivalent of a more than 3% daily move in US equities every day for the next month.
A VIX of 50 is also consistent with levels previously reached during the 2008 global financial crisis and the 2011 Eurozone crisis. But this time, we don't think it indicates fundamental problems for equities, and appears largely technically driven. Exchange-traded products (ETPs), which had shorted the VIX, were forced to cover shorts as volatility rose last Friday, exacerbating the move higher in implied volatility. Now that nearly all the value in short volatility ETPs has been wiped out, they are unlikely to remain a source of long-term VIX buying pressure. Indeed, longer-dated VIX contracts show a much more modest rise in volatility. VIX September 2018 contracts are trading at 18.2, close to the index's 20-year median of 18.6.
Looking ahead, volatility should trend near more normal levels. But a return to the abnormally calm markets of recent months is unlikely. Concerns about central bank tightening, stemming from higher US inflation, which surfaced on Friday, are likely to re-emerge in the months ahead. We think markets can still move higher over the next six months, driven by good economic data and corporate earnings growth, but the smooth sailing is likely over.
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