Why Is the VIX So Low?
The CBOE Volatility Index (VIX), one of the best measures of market uncertainty, persists in puzzling traders and investors with low readings. In 2013, the daily average value of the VIX was less than 14; since 1995, only 2005 and 2006 have seen lower figures, when the VIX averaged between 12 and 13. And given low cash rates and a reasonably constructive economic backdrop, the VIX could stay within its lower bounds this year too.
The forward-looking index, which is built on implied volatility of a wide range of S&P 500 index options, accurately captures the cost of premiums within options markets. The premiums, which loosely correspond with market risk, rise when the fear of falling equity prices increases and decline as the fear of falling equity prices decreases. Equity prices, in turn, are most sensitive to economic slowdowns and rising sovereign credit risks, both of which presage falling corporate earnings. High equity valuations and rising interest rates are other flashpoints of uncertainty for equity investors.
Over its 21-year history, the VIX index has averaged 21, with periods of calm and optimism typically registering between 10 and 15, and periods of fear ranging from 30 to 40, with spikes higher.
A recent three-week period of rising uncertainty pushed up the index from 12 to as high as 21.5 on Feb. 3. That reading, the highest in more than a year, was triggered by investor concern about sovereign credit risk in emerging markets including Argentina, Turkey, South Africa and Russia. The mini-panic was caused partly by the ongoing reduction in U.S. monetary stimulus, which is fanning fears that debt-laden emerging-market economies may have difficulty funding economic growth and current account deficits. Given the S&P 500’s reliance on global economies for sales and earnings growth, some fear also flowed back to U.S. equity markets.
While the concern abated and the VIX receded to 14.5 as of Feb. 11, the period of volatile volatility was the latest episode in a long history of sovereign credit risk inciting fear. For instance, in 1997, Asian currency crises began as localized currency stress in Thailand, before spreading to Malaysia, Indonesia and the Philippines, and then South Korea, Hong Kong and China. The contagion eventually reached the U.S., and in October 1997, the S&P 500 fell 8% and the VIX rose to 40. Another sovereign crisis followed in 1998 as Russia defaulted on its debt, leading to the collapse of Long Term Capital Management, a large U.S. hedge fund. As fears of a financial panic rose, the VIX neared 46 and U.S. equity markets fell more than 20% from July to October. Markets eventually settled after central banks cut rates and IMF and local policy makers worldwide responded with rescue packages and financial aid. More recent flare-ups were the European sovereign crises of 2010, when fear about a potential Greek default pushed the VIX to 44, and then a U.S. credit downgrade and uncertainties about a self-induced U.S. debt default, which touched off a stock drop and VIX surge towards 50 late in the summer of 2011.
Recessions and fears of falling corporate earnings are other key drivers of uncertainty, as both the 1990 and 2000 slowdowns caused the VIX to rise towards 40. The 2008-09 ‘Great Recession’, which was precipitated by major banking crises and fears of systemic risk, caused the VIX to skyrocket to 80, the highest level on record.
Higher valuations and rising rates, as experienced in October 1987 and during the post tech mania period of 2000-2002, have also seen large spikes in VIX levels. A rising short rate environment in 1994, wherein the Fed raised rates seven times in one year, also saw the VIX spike from below 10 to above 20 in a matter of months.
On the flip side, periods of relative complacency have generally occurred during mid-cycle of an economic expansion, when recessionary risk was low and credit-default fears minimal. Examples include 1993-1996 and 2004-2006, when the VIX averaged less than 13. Given that the three previous U.S. economic cycles have averaged eight years, that puts 2013 as year #4 of the recovery, solidly at the mid-cycle stage and helps explains the low level of uncertainty. With a 4.1% U.S. GDP print in Q3 2013 and 3.2% in Q4, the 2014 economic backdrop retains the potential for another below-average VIX year.
On the down side, history suggests that the recent turnover of the Fed Chairman soon will be followed by some trouble. Within the first year of appointment for each of Volcker, Greenspan and Bernanke, major crises erupted; Volcker dealt with a deep recession in 1980, Greenspan with Black Monday in October 1987, and Bernanke with the expanding but still-latent financial credit crises in 2007. With Janet Yellen beginning her first year and a sovereign currency crises simmering, markets need to navigate through yet another period of jitters.
Despite the year’s rocky start, the U.S. economic recovery is expected to accelerate towards 3% growth, which would be the highest since 2005. The Fed standing pat on short rates would remove another key source of uncertainty, and the 10-year Treasury back down to 2.6% provides another leg of support. Looking out to 2015 though, with the Fed taper completed and the recovery in its latter with rising short and long rates very likely, the underlying uncertainty will almost certainly rise.