By Saikat Chatterjee and Thyagaraju Adinarayan
LONDON (Reuters) – Stock and currency fear gauges that soared to the levels of the 2008 global financial crisis have become less frantic since central banks and governments stepped up efforts to combat spreading economic damage from the coronavirus epidemic.
But while that decline in market volatility will offer some respite to battered investors, it is too soon to declare that markets have bottomed out after a 30% cliff-edge drop from record highs.
The Cboe Volatility Index <.VIX>, known as Wall Street’s fear gauge, is at 52 points, well below its March 16 record closing high of 82.7.
“To get investors back into the market I really would like to see the VIX not making new highs,” said Andrew Sheets, head of cross-asset strategy at Morgan Stanley in London.
“That would be a positive sign and consistent with the market bottoms we saw in 2009, 2016 etc.”
The stock market selloff led investors to draw comparisons with the 2008 crisis, when markets bottomed six months after the VIX blow out.
(Graphic: VIX top, market bottom 2008 vs 2020, https://fingfx.thomsonreuters.com/gfx/buzzifr/15/9979/9979/Pasted%20Image.jpg)
Currency volatility has also throttled back, though it remains relatively high.
A Deutsche Bank index for currency volatility <.DBCVIX> in recent days jumped to its highest in its eight-year old history, pressuring hedge funds and risk parity funds to unwind leveraged positions in a selloff characterized as a value-at-risk shock.
The Deutsche indicator has retreated over the last two sessions but remains as 14%, twice its life-time average.
Prior to the coronavirus-induced reversal, bets against volatility enjoyed a long run of popularity that continued up to January and with net short positions on VIX futures contracts <11170E1NNET> hitting a record at end-2019 as investors remained convinced that policymakers would keep market fluctuations in check.
Now, massive stimulus from central banks and governments – including Monday’s announcement by the Fed that it would buy unlimited bonds and backstop direct loans to companies – “has stabilized market volatility to some extent,” said Vasileios Gkionakis, head of FX strategy at Lombard Odier.
Traders typically set limits against potential losses in their operations by calculating VaR – a statistical measure used to quantify an expected loss over a specified horizon at a certain confidence level in normal markets.
VaR can tell a bank’s management how big the following day’s maximum loss for a trading floor might be. Based on previous market volatility and return metrics, a lower VAR reading would encourage traders to raise the size of their trading positions in a low volatility environment, and vice versa.
When volatility jumps as happened when the coronavirus started spreading across the globe, these investors exceed their limits, forcing them to cut positions rapidly in a falling market. JP Morgan calculated that last week’s VaR shock was the biggest since Lehman collapsed in September 2008.
The VIX equity gauge typically jumps at times of panic among investors, and markets remain worried that lockdowns caused by the virus could trigger the deepest recession in decades.
“We are moving 4% a day and that kind of high vol is unhealthy. I think that vol needs to stabilize before the broader market can heal,” Morgan Stanley’s Sheets added.
(Graphic: FX volatility, https://fingfx.thomsonreuters.com/gfx/mkt/13/3859/3820/FX%20volatility.png)
(Reporting by Saikat Chatterjee, Thyagaraju Adinarayan and Sujata Rao; editing by John Stonestreet)