Volatility Market Signals the Stock Pain Isn't Going Away Soon

(Bloomberg) -- The options market has a message for equity traders: Get used to the mayhem.

Volatility has surged to levels not seen in more than a year as investors try to gauge the risks to global growth from the coronavirus’s spread. The VIX Index, which tracks the implied volatility of the S&P 500 over the next month based on out-of-the-money options prices, peaked above 30 on Tuesday during the broadest two-day sell-off in this decade-long bull market.

Beyond the headline spike for the so-called fear gauge, there’s an even more worrying signal for investors who take a deeper look into the byzantine machinery of the derivatives market. The VIX curve is in so-called backwardation, with the March futures contract trading about 1.5 points above April’s, a departure from the usual upward slope to the curve and a telltale sign of a stock market gripped by panic.

And what makes this inversion scarier than normal is what’s happening just a bit further out on the curve. Typically, when the front of the VIX curve inverts, the rest stays relatively flat. It’s an acknowledgment that the market tumult is expected to be a relatively short-lived affair.

Not so this time. The April VIX future has closed as much as 1.3 points above May’s during this pullback, the biggest such backwardation between the second and third-month contracts since the idiosyncratic volatility blowup in February 2018. This is an indication that traders expect an environment of heightened volatility to persist for longer than your run-of-the-mill stock market correction.

This dynamic speaks to the evolution of traders’ perception of the coronavirus: what was first a contained supply shock is now morphing into a potent threat of unknown magnitude to a fragile global economy.

After stock-market wipeouts Monday and Tuesday, the concern was evident again Wednesday, with the S&P 500 slumping in a wild day of trading that erased an intraday gain that peaked at 1.7%.

The recent rout has seen overnight selling worsen materially once regular trading hours begin. Over the past five sessions, the SPDR S&P 500 ETF Trust has opened half a percent below the prior day’s close, on average, and subsequently sold off more than 1% thereafter. That combination is rare: since the start of 2010, it’s happened only during the volatility spike in 2018, fears of a Chinese hard landing in August 2015 and the debt ceiling debacle and European debt crisis in 2011.

It could take months to know the severity of the hit as data trickle out, and an eventful political calendar and uncertain Federal Reserve reaction to this new risk could emerge as powerful market catalysts, to boot.

“Part of that, where the second and third VIX futures contracts are more inverted, has to do with all these events starting to play out,” said Stacey Gilbert, a money manager at Glenmede Investment Management. “That’s really the crux of this. We don’t have a full grasp of the total potential impact on global growth.”

This is a similar, but even bigger, premium than existed when markets were tumbling in August 2015 as part of a belated overreaction to the devaluation of the Chinese yuan, another global economic scare that roiled assets. Ultimately, the S&P 500 Index didn’t find a bottom until February 2016.

To contact the reporter on this story: Luke Kawa in New York at lkawa@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Brendan Walsh, Rita Nazareth

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