Can the SKEW/VIX predict market corrections?

Over the past few years, we have developed a series of indicators of market complacency in order to prevent investors of a sudden spike in price volatility after a long period of calm. One of them looks at the divergence between the Economic Policy Uncertainty EPU index (Baker et al., 2016), a measure of economic uncertainty based on newspaper coverage frequency, and the VIX. Figure 1 (right frame) shows that over the past few years, the EPU index has been displaying a much higher risk level that would be inferred from the options market. Some also watch the activity in the TED spread, which has been distorted since the financial crisis due to a tightening up of regulations and changes in money market funds (figure 1, right frame), and notice when it starts to stir.

Figure 1

Fig1 New

Source: Eikon Reuters

An interesting one looks at the behavior of the SKEW index relative to the VIX. As we previously mentioned, since the crash of October 1987 (Black Monday, DJ down 22.6%), investors have realized that S&P500 tail risk (returns that are under 2 or more standard deviations below the mean) is significantly greater than under a log-normal distribution. Therefore, the ‘skew’ measures the perceived tail risk of the market via the pricing of OTM options. A rise in skew indicates that ‘crash protection’ is in demand among institutional investors. A ‘low VIX/high skew’ combination says that the market is complacent, however the ‘big players’ perceive far more tail risk than usually. Therefore, a surprise increase in realized volatility may not be too far away.

Figure 2 shows the times series of the VIX, the SKEW and the weekly change in the SP500. As you can see, a sustain period of falling VIX and rising SKEW is generally followed by a sharp spike in implied volatility. For instance, while the VIX was approaching the 10 level in the summer of 2014, the SKEW index had been on a rise in the year preceding that period, rising from 113 in July 2013 to 146 in September 2014. In addition, the Fed stepped out of the bond market in October 2014 (end of QE3) and therefore exacerbated investors’ concern on the market. We then saw huge moves in both equities and bonds in the middle of that month and the 18-month period that followed was basically a flat equity market with some significant drawdowns (October 2014, August 2015 and December 2015 / January 2016). The second period we highlighted was in 2016 / 2017, which was marked by an extremely low volatility and a rising SKEW. We saw that things reverted drastically in the February VIX-termination event. Following this event, we eventually had another period of falling VIX and rising SKEW in the next months before the October sell-off. We can notice in the chart that the SKEW does not stay above the 150 threshold for too long, hence a VIX trading at around 12 and a SKEW at 150 were last summer were indicating a potential market turmoil.

Figure 2

Fig2 New (1)

Source: Eikon Reuters

The SKEW/VIX behavior does not predict a market correction all the time (i.e. the SKEW had been falling for months prior the August 2015 sell-off), however we think that investors should remain cautious when the SKEW starts to rise above 140 and the VIX remains low. While a falling VIX would push investors to increase their leverage (target vol strategies or risk parity funds), we think that looking at the two variables for portfolio construction could help reduce the potential drawdowns.

FX Cross-Currency Basis Swaps and Hedging Costs

One interesting topic in the FX market that has been closely studied by both academics and practitioners over the past decade is the violation of the covered interest parity (CIP). CIP is a textbook no-arbitrage condition that states that interest rate differential between two currencies should equal the differential between the forward and spot exchange rates. In other words, in discrete time, we have the following condition:

Where S is the spot exchange rate, F is the forward exchange rate, i is the domestic interest rate and i* is the foreign currency interest rate. The problem is that the above equation has held since the Great Financial Crisis; as it started to become more expensive to borrow US Dollars against most currencies during periods of stress, the cross-currency basis swap (CCBS) has been diverging from zero for the Euro, the British pound and the Japanese Yen. Figure 1 (left frame) shows the evolution of the 3-month CCBS for the three currencies (against the USD) since 2012.

Low interest rates combined with the significant divergence in unconventional monetary policies run by the BoJ and ECB over the years has put pressure on the exchange rates and the CCBS, and therefore has increased the hedging costs for Euro and Japanese investors. The current rate on the US 10Y Treasuries (3.15%) looks certainly very interesting for unhedged international investors (relative to domestic bonds such as in the Euro area or Japan), however changes drastically when we adjust for hedging costs. Figure 2 represents the cash-flows that occur at the start, during the term and at maturity when a Euro investor (A) enters a cross currency basis swap. As you can see, each quarter A pays the 3M USD Libor and receives the 3M Euribor and the basis. Hence, the more negative is the basis, the higher the hedging cost. With the 3M Euribor at -0.316%, the 3M CCBS at -44bps and the 3M Libor USD at 2.61%, the current return on a FX-hedged 10Y US Treasuries is negative (-20bps). Figure 1 (right frame) shows that despite the rise in US yields since the middle 2016, it has been falling for Euro and JPY investors after adjusting for FX hedging costs. A UK investor would get an annual return of 1.35%, which is 15bps below he can get in holding a 10Y Gilt.

Figure 1

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Source: Eikon Reuters

 

Figure 2

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Source: BIS