Merrill Lynch strategists presented a compelling argument that investors' desperations for yield, combined with equity market complacency, sets the stage for a sharp spike in volatility and a painful equity market sell-off.
Foreign exchange strategist Christopher Xiao noted that short positions on the CBOE Volatility index (or VIX index – it uses futures prices to predict market volatility) have hit record highs. He believes that hedge funds and other sophisticated investors are short-selling the VIX in futures and options markets, and using the proceeds to buy exposure to higher yielding sectors like emerging markets and high yield bonds.
This trade – short the VIX and long high yield bonds – is called a carry trade. Basically, the short positions are "carried" and the funds generated by the short (selling a call option, for instance) provide the funding to buy investments benefiting from higher income levels. It works as long as the VIX stays low, making the short position cheaper to close out or "cover" and yields stay elevated relative to government bonds.
Mr. Xiao believes the popularity of the carry trade among hedge funds could cause serious problems for the market, "Selling [the VIX index] to enhance yield is now at an extreme level, with net speculative VIX exposure at all-time shorts ... [this] could set up the market for a highly volatile and correlated sell-off on the next shock. Carry trades that look attractive due to severely depressed volatility levels could unwind on even a modest increase in volatility."
The word "unwind" sounds innocuous in this context but it's really not. To unwind the carry trade, a manager must both buy back their exposure in the VIX – which, if a lot of them had to do it at once would cause a big spike in the index and scare all equity investors – and sell the higher-yielding asset they were holding as the long. The selling would cause a downdraft in emerging market bonds, high yield corporate bonds, and other popular yield bearing instruments.
The two charts below highlight one way the carry trade is likely working in current markets. The first chart highlights that, as Mr. Xiao noted, futures positioning in the VIX is the shortest in history.
The second chart uses the iShares JP Morgan USD Emerging Markets Bond ETF as an example of an investment that benefits from higher yields and could very well form the "long" side of the carry trade.
The chart shows the huge surge in call options – contracts that increase in value as the price of the ETF climbs – since June of 2016. This is consistent with the idea that hedge funds are shorting the VIX and buying derivatives to benefit from high yield sectors.
The VIX index is already trading at levels Mr. Xiao calls "severely depressed" with the inference that the index's next move will be higher. The sell VIX/buy high yield carry trade is so crowded at the moment that it won't take much of a move higher to have managers across the globe scrambling to unwind their positions, much to the detriment of markets as a whole.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online. Subscribe to Globe Unlimited at globeandmail.com/globeunlimited.