An early warning alarm must be a good idea..... but which one?

 

ref :- "Move over VIX", Buttonwood in the Economist May 22 - 28, Finance and Economics

Regulars will know that every now and again we like to drop in on the VIX, the CBoE's Volatility Index. Well, when something gains the moniker of "The Fear Index" you've got to keep at least half an eye on it, haven't you? The level of the VIX reflects the cost of options on the S&P 500, and a rising VIX number suggests that investors are prepared to pay more for insurance against extreme moves in share prices. In other words, the higher the price of the VIX, the more nervous the investors ... hence the nickname.

The VIX is a very useful tool, not just in its role as an obvious ringer of alarm bells but more broadly in aiding asset managers large and small to manage risk more effectively. But it's not the only measure that might be referred to as a Fear Index and the Economist is telling us that right now we'd be better off following another one  --  the MOVE, or the Merrill Lynch Options Volatility Estimate. The MOVE has been around since the 1990's but has had a lower profile than the celebrated VIX. It calculates volatility in a similar way but in this case it's level reflects the prices of one-month options on 2,5,10 and 30 year US Treasuries rather than a stock index like the S&P500.

Buttonwood's logic seems to make sense: the biggest worry for fund managers has shifted from a Pandemic, which obviously affects the performance of companies (and therefore their share price) in the most fundamental way, to fears of an inflation spike likely to be countered by rises in interest rates. That being the case, why wouldn't you follow a fear gauge based directly on interest rates and how they might move in the future? All must be well aware by now of all the reasons why inflation MIGHT become a big issue  --  ultra-loose monetary policy, massive fiscal stimulus, strains in supply chains etc. --  but it's by no means certain that it will. The Fed are maintaining their view that inevitable rises in inflation as the US emerges from Covid will be transitory and will not affect their monetary policy plans. But if bond investors lose their bottle and cease to believe the central bank, you'll see it on the MOVE first.

The current level of the MOVE is 54.59, which in fact is some way below the long-term average. It went through 250.00 when Lehman's collapsed for example, and it's instructive to look at the long-term chart in the Economist piece and match the spikes to events (e.g. Taper Tantrum). As they point out, the current low level is largely technical in nature and reflects a Fed policy committed to ultra-low but not negative rates. In other words, you can't expect anything but lower than average volatility within such a tight band but a rise in the measure will reflect investors concern that the Fed's pre-stated plans may be cracking.

We're quite fond of these types of index. One has got to be wary of calling them predictive .... strictly speaking, they're not of course. But they do signal changes in market sentiment and even if they're not predictive per se they can be used as part of a tool kit that can highlight the upcoming danger. One would expect Harley Bassman, who created the MOVE, to be fairly enthusiastic about its usefulness but speaking when the ICE acquired the Index from Bank of America Merrill Lynch, he put it rather well :

"While I would not call it predictive in isolation, rare is the case where a simultaneously low MOVE, flat Yield Curve and tight Corporate Spreads (narrow premium charged for corporate debt over Treasuries) are not soon followed by bothersome market conditions".

"Bothersome" .... nice. 

But there we have it .... from a prediction point of view, perhaps the MOVE (and others) is most useful in identifying the kind of complacency that could contribute to a major market reverse. A rising MOVE level that indicates that traders are paying up for insurance is also interesting of course, but in this instance would tell us something that we already know .... that the market is getting pretty sweaty about this inflation thing.