Correlations closed at .5, the highest point in the past month and reasonably so given Friday’s price action.
As we increase in correlations, short term realized volatility tends higher than 21 day and longer term volatility at the 95th percentile level (red arrow), the range of possible price outcomes in the short term increases significantly. As of Friday’s close our model shows that vix is appropriately priced by market participants.
That being said, in the short term we believe that now any and all of our 10 day forecasts which were bullish are now invalidated based on Friday’s price action. We would not at all be surprised to see more volatility in the short term.
In one of our daily posts two weeks ago we mentioned to be on high alert for a prompt vs. prompt+1 vix futures inversion because a narrow spread of .4 could lead to that effortlessly. As of today that spread has narrowed by half to .21 points. The best way to think about a curve inversion is that something significant is happening right now. You don’t know if in 2 months time the issue will be resolved, but you do know that whatever is happening now justifies a high price due to extreme uncertainty.
Curve inversions happen frequently in energy related products including electricity (more-so because it is cannot be stored, only transmitted) and natural gas (less so because gas can be stored) which are heavily influenced by weather. If it is extremely cold in a given month and there are supply constraints the physical product inverts massively over the futures products. You need electricity to heat your home now – or things could get really bad.
So how does this relate to the VIX curve today? Basically an inversion of the vix curve today would signal that market participants are taking the Corona virus very seriously. In the short term hedges are demanded because uncertainty is very high.
We will be look for clues that any downside risk has exhausted itself in the coming weeks. One such clue would be extremely high correlations in the .85-1 range. This has always produced an extremely favorable risk to reward proposition for the upside.