On Tuesday, September 29, the VIX closed at 16.03, according to Cboe, after closing at 14.87 on September 25. Cboe described the index in its note for the week of September 28 as hovering near a one-year low around 14.9. On the same day the 10-year U.S. Treasury yield traded around 5.25%, its highest level since mid-2007, according to Admirals. The Federal Reserve raised its target range by 25 basis points to 3.75% to 4.00% on September 16, and the market that sells protection against a stock decline is now charging less for it than it did on the day of the hike.
Cboe data show where the money went. The one-month skew on the S&P 500 sits in its 5th percentile, investors are rotating out of hedges and into upside calls, and about 40% of the 100 largest stocks trade with inverted call skew, meaning upside calls carry a premium over comparable puts. Single-stock implied volatility rose a further two points to 38.5% in the same note, so the calm is concentrated in the index while individual stocks are priced for larger moves. Cboe also noted that the rise in yields came almost entirely from higher real yields rather than higher inflation expectations, which means financial conditions are tightening.
Probability Weighting Makes the Right Tail Feel Worth Paying For
Amos Tversky and Daniel Kahneman, in their 1992 cumulative prospect theory paper, showed that people overweight small probabilities of extreme outcomes, the same distortion that sells lottery tickets. Alok Kumar, in a 2009 Journal of Finance study, found that individual investors concentrate in lottery-like stocks, those with a small chance of a very large payoff. An options market that pays a premium for upside calls while paying less for downside puts expresses the same preference in derivatives.
A premium for calls does not prove that investors are wrong. It shows what they are buying: a small-dollar claim on a large gain, at a moment when the price of the opposite protection has fallen. Brad Barber and Terrance Odean, in a 2000 study of 66,465 households at a large discount broker, found that the fifth of households that traded most earned 11.4% a year from 1991 to 1996, against 17.9% for the market. Activity felt like skill and cost money.
Availability Turned One Quiet Session Into a Rule
Tversky and Kahneman described the availability heuristic in 1974: people judge how likely an event is by how easily an example comes to mind. The most recent rate shock is the September 16 hike, and it was absorbed quickly. Fed funds futures priced a 92% likelihood of the hike before the announcement, according to American Banker, so the decision removed uncertainty rather than adding it.
The VIX fell 12.8% in the single session after the hike, reached 14.21 on September 22 and has recovered only to 16.03, still below the 17.71 it closed at on the day of the decision.
The series shows daily closes for the 14 sessions from September 10 to September 29. The Federal Reserve raised its target range to 3.75% to 4.00% on September 16.
Over the same stretch the 10-year yield moved from 5.01% on September 16, according to BondSavvy, to about 5.25%, a rise of roughly 24 basis points while protection got cheaper. The vivid memory is a hike that was absorbed in a day. The less vivid fact is that higher real yields are a slower cost, repriced through valuations rather than through a single headline. New York Fed President John Williams said on September 24 that another hike by year-end was a reasonable expectation, according to Admirals.
The Canadian Gauge Is Calm Too, and the Calendar Is Not
The S&P/TSX 60 VIX closed at 13.67 on Tuesday, according to Investing.com, even though the S&P/TSX Composite fell 311.03 points, or 0.87%, on Monday to 35,489.86, its lowest close in about eight weeks according to Fool.ca. The composite closed at 35,460.27 on Tuesday, down a further 0.08%. At 13.67 of implied annual volatility, a one-standard-deviation daily move is about 0.86% (HDQ calculation: 13.67 divided by the square root of 252), so Monday was roughly a one-sigma day priced as if it were routine.
The domestic calendar gives the calm a test date. Statistics Canada reported flat GDP in July and a flash estimate of 0.2% growth for August, the Bank of Canada has held at 2.25% for seven straight decisions, and overnight index swap pricing implied a 59% probability of a hike on October 28 as of September 25, according to BlueGamma. September CPI arrives on October 19. Capital Economics said in a September 17 note that the October decision would be a narrow call, with no hike as its base case, which leaves a wide band of outcomes for a market priced for calm.