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Goldman Warns, VIX "Is Pricing In A Lot Of Economic Damage"

If the market is right, Goldman warns that current cross-asset-class volatility appears to be pricing in a lot of economic damage. As they note, VIX doesn’t just trade the economy; it also has a strong and often humbling element of risk sentiment baked in.

 

Goldman Sachs explains...

Mapping VIX levels back versus the economy … weaker data = higher VIX

Understanding the interplay between volatility and the economic cycle has been a core theme underlying our volatility framework. Although the VIX is often considered a “sentiment indicator”, a regression of average calendar month VIX levels on U.S. consumer spending, manufacturing and employment data explains 59% of the variability in VIX levels back to 2000. Updating our model to include last week’s ISM and employment data suggests that if the VIX were trading off the recent economic data then average VIX levels should be tracking at 18. The average VIX level in August was 19.4 and the average since mid-August has been 25.9, with a closing high of 40.7 on August 24.

Baseline VIX: ISM in low 50’s suggests equilibrium VIX level of 18, even after controlling for the drop in unemployment rate

We estimate that baseline VIX levels tend to increase about one-half of a vol point for every one-point decline in ISM new orders. ISM new orders levels averaged about 10 points higher over the back half of last year relative to where they are now (2H 2014 avg: 61.4 vs current: 51.7), so baseline VIX levels should be about 5 vol points higher. The average VIX level over 2H 2014 was 14.6. An estimate for the average VIX level given just the shift in new orders is approximately 19.7 (14.6 + 0.52*(61.4-51.7) ). Controlling for the drop in the unemployment rate to 5.1% puts our model at 18. A similar analysis on one-month S&P 500 realized volatility suggests current levels of 14.6.

The median daily VIX level over the last three recessions has been 26

The VIX closed at 27.8 last Friday. VIX levels go back to January 1990. Since that time there have been three recessions. Average VIX levels in the first two recessions (1990-1991, 2001) were 25 and 26 respectively. The worst of the worst was, of course, the Great Financial Crisis; average VIX levels in this 2008-2009 recession were 34. The median daily VIX level across all three recessions was 26, with an average of 30, skewed to the upside  due to vol spikes. Our point is simply that the VIX at 27.8 is in that range and appears to be pricing in a lot of economic damage.

But VIX fits with the rest of the market's perception...cross asset metrics point to a VIX level of 25-27; VIX is in line with EM FX, HY, oil, rates


 
Updating the analysis from last week in Exhibit 9 suggests a predicted VIX level of 27.2 versus an actual closing VIX level of 27.8 on September 4. The regression in Exhibit 10 replaces EM FX with EM FX 1m implieds, WTI with WTI 1m implieds and 2y UST yields with 1m2y swaption vol and suggests a VIX level of 24.8. Relative to last week the cross asset risk metrics pushed higher to suggest a higher closing VIX level. Much of that came from a rise in US HY spreads and EM FX.

Ahead of The FOMC Meeting, Cross asset volatility levels are higher across the board consistent with higher VIX levels

What made 2014 stand out from prior low vol environments is that volatility and spread levels were low across various asset classes at the same time. By mid-year 2014, credit spreads had dropped and implied volatility levels across equities, commodities, rates and FX had all fallen to near decade lows. The VIX dropped to 10.3 in July 2014. Fast forward to 2015, and cross asset volatility levels have pushed higher across the board. Exhibit 11 looks at the percentile rank of the current level of implied volatility across global equity indices, EM and DM FX, commodities and US interest rates and compares versus July 3, 2014 (VIX cycle low). US interest rate implied volatility (1m10y), US HY CDX spreads and copper implieds are the only risk metrics on that dashboard trading below median levels back to 2004.

Exhibit 12 shows a metric of aggregate cross asset volatility, comprised of average 3m implied volatility levels across 21 global equity indices, fourteen EM FX currency pairs versus the USD, nine DM FX currency pairs versus USD, CDX IG 5y, CDX HY 5y, Copper, WTI and 3m10y and 3m2y US rate implied volatility. If we take that exhibit as a proxy for the global aggregate level of cross asset risk, then risk is now back on par with late-2014, early-2015 levels.

The VIX doesn’t just trade the economy; it also has a strong and often humbling element of risk sentiment baked in. The market in 2015 is worried about a potential FED rate hike during deteriorating financial conditions and a mixed U.S. and global economic picture. China’s currency devaluation and the residual impact across the EM and DM landscape are also front and center. Once the VIX is elevated, the healing process can take a long time.