The beauty of looking at cross assets is that they tell us a story usually missed by individual asset classes. Generally, each asset class tends to move in its own little merry world based on its own fundamental drivers and flow. However, on some higher level, they all "should" tell the same story, otherwise there is a disconnect or an arbitrage of sorts. These do tend to happen when flows in one get so exaggerated that it tends to break away. That is when eyebrows should be raised as discrepancies are found. Trading cross asset is harder than understanding it, but the stories they reveal are extremely important as they generally do filter down to each asset class over time.
The volatility or derivatives market is one of the most important asset classes, its size is in trillions and more if one counts all the over-the-counter stuff as well. It is one of the most levered asset classes out there. Given its extremely technical nature, most tend to stay away from it. Today it has become a favoured way to squeeze the hedge funds of their massive short positions in illiquid names. This works well when a group of options traders buy upside calls causing the market maker to cover their upside by buying futures against it. This becomes self-fulfilling when they keep buying more and more and prices shoot higher causing a painful squeeze in illiquid stocks. Most who trade it will not even be able to tell you what the delta, gamma, or theta is for that asset. It does not matter as it is all short term. But taking a step back, trading longer term options is an entirely different beast.
The volatility of the market has been in a structural decline for years given Fed pumping endless amounts of money into the market and supporting asset classes. No one wants to buy any downside protection, puts, anymore as they are "just a waste of premium" as markets never go down, right? As volatility goes down, the index moves higher - this is an inversely correlated relationship. When an exogenous shock appears to hit the system, the volatility explodes taking markets sharply lower as it all happens super-fast. This was what happened back in March 2020 when lockdowns hit, and back in Feb 2018 when volatility funds blew up. They can happen and cause a severe stress in the system.
According to a SocGen report recently, today the leverage in volatility products is the most leveraged it has ever been. The market is very complacent. Following the GameStop (GME) debacle which caused hedge funds to unwind their positions painfully, VIX did shoot up towards $33. It is back down now, but given the sheer moves of the market in the last few weeks, it cannot go unnoticed as something seems to have snapped. When VAR models blow up, on the upside and downside, it means books need to degear to balance the risks. If one looks at the Dollar index (DXY) it's hovering around $91 level, way above the $90.5 resistance level of a multiyear downtrend. We all know the extremely one-way bias of lower for longer dollar. U.S. bond yields are slowly moving higher towards 1.13%. At what point do institutions remove their 60/40 allocation to bonds? One wonders.
Investing is about assessing the risk vs. reward. When everything is so skewed one way, it pays to look at the other side. Right now, one hiccup, and the whole system can come crumbling down. We know Daddy Fed will be there to bail us out, yet again, and print more eventually. But that does not mean the markets cannot fall significantly before they come to the rescue. When some asset classes stop moving to the mainstream mantra in place since last year, it pays to take notice. We all know how equities are the last one to wake up and smell the coffee.