February 12, 2018 / 11:39 AM / a year ago

COLUMN-Speculators in biggest ever U-turn on low volatility bets: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters)

By Jamie McGeever

LONDON, Feb 12 (Reuters) - The wild gyrations rocking global markets this month have sparked the biggest ever reversal of speculators' bets on low volatility.

For investors, this could be a game-changer. As Citi strategists told clients on Monday, "Time is Up for Goldilocks".

The suddenness and severity of the position shift suggests 2018 will be very different to 2017. Structurally higher volatility will make for a much less equity-friendly environment.

The fairy tale character who preferred her porridge neither too hot nor too cold had become synonymous with the benign monetary and economic conditions that fuelled the boom in world stocks over the past two years. The nexus of that was a prolonged period of historically (and bafflingly) low volatility.

Like all fairy tales, however, it turned out to be an illusion. Sparked by fears that U.S. inflation might be about to take off, leaving the Fed asleep at the wheel, the VIX index of implied S&P 500 volatility exploded last week.

Its rise on Monday Feb. 5 was the biggest ever, accompanying the steepest decline on Wall Street in over six years and wiping trillions off the value of world stocks. It also prompted the biggest ever shift in speculators' "low vol" bets.

Chicago Futures Trading Commission data for the week to Feb. 6 show that hedge funds and speculative investors flipped to a net long VIX futures position of 85,818 contracts.

Not only is that a record long position, the swing of over 145,000 contracts from a net short 59,357 contracts the week before was by a huge margin the biggest ever week-on-week change.

A long position on the VIX index is effectively a bet on high or rising implied volatility, and a short position is a bet implied volatility will fall or remain low.

Speculators have held an almost unbroken short VIX position for the past decade, CFTC data show, culminating in a record short 174,665 contracts in October last year.

The relationship between implied volatility and market moves is symbiotic, but it's not clear which drives which. Does low volatility push stocks higher, or does a rising market depress volatility?

Whatever the answer to that is, volatility is back and stock markets around the world are wobbling.

Wall Street and the MSCI World index have slipped into the red for the year, retail investors pulled record amounts out of global equity funds last week, and the speculative trading community has been spectacularly wrong-footed.

According to JP Morgan, so-called "Risk Parity" funds, which target specific levels of risk and risk diversification, have underperformed a hypothetical benchmark by 3.7 percent since the start of the equity market correction. That's an even bigger underperformance than that seen during the Fed's "taper tantrum" in mid-2013, when bond yields unexpectedly surged.

So-called "Commodity Trading Advisors", funds which often specialise in trading futures contracts or options on futures, lost 6.9 percent in four days from Feb. 1 to Feb. 7. Pure trend-following CTAs, designed to buy assets that are rising and sell them when they are falling, did even worse, losing 9.2 percent during these four days.

"These negative four-day returns are unprecedented, pointing to severe position unwinding," JP Morgan estimates.

Bob Prince, co-chief investment officer at Bridgewater Associates, the world's largest hedge fund with around $150 billion of assets under management, believes global markets are entering a new era of higher volatility.

"There had been a lot of complacency built up in markets over a long time, so we don't think this shakeout will be over in a matter of days," Prince told the Financial Times in an interview published on Monday. "We'll probably have a much bigger shakeout coming."

There's no magic number for the VIX that investors need to watch, but the threshold between a "high" and "low" vol environment is probably between 15 and 20 percent. Analysts at Goldman Sachs say it's 15 pct, others say it's 20 pct, and the median value of the VIX since its inception is around 17 pct.

The VIX briefly popped above 50 pct on Feb. 6 for only the second time since the global financial crisis. It's now back down to 26 pct, but crucially, hasn't gone back below 20 pct since the blowout a week ago.

Reporting by Jamie McGeever; Editing by Peter Graff

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