The Data Point That Could Bring Volatility Back

Last week's central bank meeting in Wyoming gave no new clues on the timing of future interest rate hikes

Senior Vice President of Research
Aug 29, 2016 at 9:32 AM
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 "…last week, the historical volatility (HV) reading on the S&P 500 Index (SPX - 2,183.87) was in single digits for the 15th consecutive day, the first time a consecutive streak like this occurred since December 2014. Moreover, the CBOE Volatility Index (VIX - 11.34) hit a multi-year closing low on Friday, as the VIX followed HV readings lower and option traders factored in relatively low volatility in the days and weeks ahead.

"This is especially interesting from the perspective that central bankers are scheduled to meet in Jackson Hole, Wyoming, later this week -- an event that will be closely watched by traders. With the potential for this to be a market-moving event, the risk now is very similar to that which we observed in June, ahead of a Federal Open Market Committee (FOMC) meeting and the 'Brexit' referendum."
- Monday Morning Outlook, August 22, 2016

Roughly two months after the Brexit referendum, another event garnered intense focus from traders around the world -- the annual central bankers' meeting in Jackson Hole, Wyoming. A Friday morning speech by Federal Reserve Chair Janet Yellen highlighted the meeting, in addition to comments from other Fed governors. 

In the days leading up to the Jackson Hole meeting, the broad market did very little in terms of movement, as a "wait and see" approach took hold among market participants. Looking at Friday's SPDR S&P 500 ETF Trust (SPY - 217.29) volume, in the 10:00-10:30 a.m. hour as Yellen spoke, it was the largest half-hour volume bar outside the final half hour of the day since July 27, when the Federal Open Market Committee (FOMC) last met. The noon volume bar spiked, too, as Fed Vice Chair Stanley Fischer said there is a chance that two rate hikes could occur before the end of 2016. 

I point this out not only because Fed days like Friday tend to produce unusual intraday volume, but also because the Friday lows were around the July 27 close of $216.52. So, in addition to potential option-related put support in this 216-217 area, traders may have been anchored to the close of the last FOMC meeting. 

A hawkish tone was expected going into Jackson Hole, and the headline phrase from the Fed Chair was, "…I believe the case for an increase in the federal funds rate has strengthened in recent months." Yellen's comments may have been a little short of the degree of hawkishness expected, however. For example, according to data from CME Group, the implied odds of a September rate hike (using Fed funds futures) dropped to 18% from Thursday’s 21% probability. 

But after Fischer delivered his comments around noon Eastern time, the implied odds of a September rate hike rose to 36%. After taking a step back, one might argue nothing new really came out of Jackson Hole on Friday, which is why the SPY finds itself trading around the site of the July 27 close. Consider this:

  1. In late May, Yellen hinted at a rate hike in coming months. She said a rate hike was appropriate if economic indicators remained strong. For the most part, economic data has been strong since those remarks.
  2. In late May, Yellen pointed out that stronger productivity growth would give the Fed more policy scope. On Friday, Vice Chair Stanley Fischer piggy-backed on Yellen's June comments, pointing out that productivity growth remains weak.
  3. "Data dependent" was used to describe future monetary policy -- words we have heard month after month from the Fed when it projects monetary policy going forward.

Intraday volatility picked up relative to past days, as investors bid stocks higher on Yellen's comments. For those who pay attention to options open interest, notice the intraday highs and lows for SPY on Friday were around strikes with decent-sized open interest in the vicinity of Thursday's close. For example, the put-heavy 216 and 217 strikes were the area of Friday's lows, whereas the call-heavy 219 strike marked Friday morning's high. The lows on Friday were especially interesting at the area of July 27 close, option-related support, and the SPY’s 40-day moving average, which has occasionally had importance.

SPY Open Interest Configuration August 29

SPY Daily Chart August 29

 "…While a volatility pop is a risk, the recent long period of single-digit HV suggests history is on the side of short volatility players, at least for the next two months. This is why we recommend a long volatility position as a hedge, as we are not suggesting that you reduce your long equity positions. For example, per a study our Senior Quantitative Analyst Rocky White did last week, when the SPX hits single-digit historical volatility readings 15 days in a row, the signal produces lower standard deviations of returns in the next month and two months, relative to the at-anytime readings. In other words, history suggests a low-volatility environment may be here to stay for a couple more months."
- Monday Morning Outlook, August 22, 2016

At the end of the day, SPY historical volatility is still in single digits, which ironically has been the case since July 27 -- the last FOMC meeting. Moreover, the CBOE Volatility Index (VIX - 13.65), while significantly above its August lows, continues to find resistance at 14.07 -- half its 2016 peak close -- which could be hinting at low volatility continuing.    

VIX Daily Chart August 29

The Fed is clearly watching productivity data, and the revised second quarter reading is due for release this Thursday. Could this be an economic data point that changes the Fed's outlook and acts as a catalyst for a more volatile environment? It could be, so keep that long volatility call hedge on, as large speculators on VIX futures are still in an extreme short position and could get caught off guard once again. However, our study last week suggests low volatility in the immediate weeks ahead, and the VIX is supporting this view, so keep your long equity exposure.

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