Fed Rate Cut Could Remove the VIX Floor

Traders are increasingly placing bets on higher volatility as the FOMC prepares to convene

Senior Vice President of Research
Jul 29, 2019 at 8:05 AM
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"Do not be surprised if round numbers like SPX 3,000 and Dow Jones 27,000 act as barriers in the short term. For what it's worth, SPX 3,008 is around 20% above the 2018 close, and could act in concert with SPX 3,000 as resistance. There was evidence of this resistance on Wednesday and Thursday, as the SPX effectively went sideways after a quick push up to 3,000, when Jerome Powell's prepared remarks to Congress were released before his actual appearance."
-- Monday Morning Outlook, July 15, 2019

As I said a few weeks ago, round millennium levels on the S&P 500 Index (SPX - 3,025.86) and Dow Jones Industrial Average (DJI - 27,192.45), in addition to the level that represents the SPX's 20% year-to-date (YTD) gain (at 3,008), could act as resistance in the near term. And since rallying up to these levels in mid-July, these popular benchmarks have displayed sideways action, which is a welcome alternative, from a bull's perspective, to a violent sell-off. The sideways action is working out an overbought condition, when observing the respective 14-day Relative Strength Indexes (RSI).

Additionally, per the chart below, the S&P MidCap 400 Index (MID - 1,983.14) is currently tucked below the 2,000 millennium level, which it has been doing battle with since January 2018. For what it's worth, the 20% YTD gain level on the MID is at 1,995, which -- in addition to 2,000 -- may tempt profit-taking.

Since first touching 2,000 in January 2018, the MID closed above 2,000, albeit barely, for seven consecutive weeks in the third quarter of 2018, but that was the only quarter it was north of this round number. And those closes barely above 2,000 did not bode well for bulls, as you can observe for yourself when viewing the fourth-quarter 2018 action.

mid weekly chart 0728

The SPX has not proven it can sustain a longer-term move above 3,000, but Friday's action was a start, with the index closing the week in new all-time high territory north of 3,000 and the round 20% YTD return level. It has now notched four consecutive daily closes above 3,000, topping the three consecutive closes in mid-July before being pushed back below.

spx daily chart 0728

And catalysts are on the near-term horizon, with earnings season continuing. On Friday, earnings reactions were generally good, with the number of big company stocks reacting positively running twice the number of negative reactions. This came amid an advance second-quarter gross domestic product (GDP) number that edged out expectations. Also on the agenda are renewed talks with China and, perhaps most importantly, a Federal Open Market Committee (FOMC) meeting, with decision time on Wednesday afternoon.

After the last FOMC meeting on June 20, when the Fed held rates steady, the market rallied over the next month, which it has tended to do since the rate-tightening cycle began in December 2015. Now, however, we're expected to reach the official end of the tightening cycle, with fed funds futures traders placing a 100% probability that the Fed eases on Wednesday. They're implying an 80% chance that a 25-basis point (bps) cut is coming and a 20% chance of a 50-bps cut. (Despite Friday's solid GDP report, expectations following the data did not change much from Thursday.)

Amid trade and Brexit uncertainty, market participants are seeking a rate cut, implying a rate hold may not yield the bullish tendencies of the past. But if market participants get what they want, the SPX and other equity benchmarks could finally sustain moves above millennium levels, whether that be DJI 27,000, MID 2,000, or SPX 3,000 as investors welcome stronger-than-expected growth and a Fed in accommodative mode as perceived risks to economic growth remain unresolved.

While investors are not exactly pessimistic with the SPX notching new all-time highs and the Nasdaq Composite (IXIC - 8,330.21) in all-time high territory and well above the 8,000 level, they are not exactly euphoric either. Perhaps macro uncertainties or the inability of smaller-cap indexes to match the action in the larger-cap benchmarks is keeping a lid on euphoria.

And while short interest is not at extreme highs on SPX and the Invesco QQQ Trust (QQQ - 195.29) components, I find it interesting that it has been growing since May -- not exactly a sign of an abundance of enthusiasm, especially in the context of these benchmarks trading at all-time highs.

qqq component short interest 0726

Per the chart below, there is an abundance of pessimism on Russell 2000 Index (RUT - 1,578.97) components -- an index that is well below its all-time high, but is up 17% in 2019. Short interest is higher by nearly 7% on component names and near an all-time high. Despite a lot of media attention about the underperformance of small caps, the RUT could be the biggest beneficiary of short covering, especially if it rallies above resistance at 1,600 amid an accommodative Fed.

rut component short interest with iwm 0726

Volatility expectations can hint at stock market sentiment, as expectations for higher volatility, as measured by the Cboe Volatility Index (VIX - 12.16) and VIX futures, likely means investors bracing for a correction. We are seeing a mixed picture here on volatility expectations. For example, in the futures market, historically wrong-way large speculators on VIX futures (as measured by the weekly Commitments of Traders reports) are nearing an extreme net short position, which raises the risk of a volatility explosion.

However, the risk is mitigated by fund players. In the month of July, there have been inflows into funds that are plays on higher volatility ahead, such as the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) and the Velocity Shares Daily 2x VIX Short-Term ETN (TVIX). Moreover, we are seeing outflows from funds that bet on lower volatility, such as the ProShares Short VIX Short-Term Futures ETF (SVXY). This data is per etf.com.

Furthermore, option speculators are seeing higher volatility in the days ahead, as is evidenced by the ratio of buy-to-open call volume relative to buy-to-open put volume on VIX futures during the past 20 days. Note in the chart below that this ratio moved above 6.0 on July 25, which is an extreme.

vix 20-day call-put ratio 0726

I asked Schaeffer's Quantitative Analyst Chris Prybal about the historical short-term, intermediate-term, and longer-term implications regarding SPX price action after a period where option speculators on VIX futures are nearly unanimous in their expectations for higher volatility ahead, such as now. His study yielded the results below. Admittedly, there are not a lot of signals -- but the small sample size suggests little cause for immediate concern, albeit heightened odds of a selloff or historical underperformance beginning a month to a year out.

spx returns after vix call-put ratio signals

Just as the Fed has claimed to be "data dependent," SPX and VIX action following a period of brisk call activity on VIX futures could be "Fed dependent." In other words, an accommodative Fed will likely mean a huge majority of VIX call open interest expires worthless, whereas a Fed that doesn't give investors (and Trump) what they want could mean huge short-covering in the volatility futures market that makes volatility surge amid falling stock prices.

As for the VIX itself, it comes into the week trading below 12.71, which is the level 50% below its 2018 close of 25.42. The 12-13 area has been a VIX floor in 2019, so from this perspective, there is growing risk of a slight (to sharp) uptick in volatility in the immediate days ahead. But Wednesday's FOMC meeting likely has volatility expectations inflated, and this VIX "floor" could easily be removed once near-term FOMC risk is removed via a rate cut.

Todd Salamone is Schaeffer's Senior V.P. of Research.

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