Nuclear Risk

The VIX is pricing in nuclear war risk, as the realized vol is badly lagging behind implied vol over the past 4 trading days.  Overnight VIX levels are trading at 33.8.  A VIX of 32 implies daily 2% moves.  Since last Friday, the SPX has moved the following:  -0.24%, -1.55%, +1.86%, -0.53%.  If you are counting the current level of the futures, the SPX is down a little over 1% this week.  

The divergence between realized and implied vol eventually converges to its historical level, which is around 3-5 VIX points.  Right now, over the past 4 days, that IV to RV premium is hovering around 15.  These kind of bloated implied vols are usually present around big events, like a 2020 Presidential election.  This time, the event is something that is everyone's biggest fear:  nuclear war.   

The market got a big scare when a Ukranian nuclear plant got hit and a fire broke out.  Eventually the fire was put out, but you still have the leftover nuclear jitters and of course weekend war risk, which is now being priced in as the futures sink pre-market.  

During the past 4 trading sessions, the divergence between the Eurostoxx and SPX has been dramatic.  Europe is making lower lows, and has broken the Thursday 2/23 Russian invasion panic low, while the SPX is still trading above 4300, well above last Thursday's levels.  A lot of risk is being priced into European equities, and much less is being priced in for the US.  It seems like the US stock market is considered a relative safe haven for risk-on flows, less affected by the repercussions of the war than Europe.  

We are still chopping around in the 4300 to 4400 range over the last few days, almost like a mirror image of the chop that we saw between 4280 and 4430 in late January.  This time, the fear is more palpable, although the realized vol is less.  If the market stabilizes and stays within this 4300-4400 range, the VIX will naturally drift lower as the IV-RV relationship converges to its historical relationship.  

On Wednesday, Powell all but put 25 bps rate hike in stone for March, but seems to be considering the aftereffects of Ukraine, which probably takes out 1 or 2 rate hikes he would have probably pushed through if there were no geopolitical risks out there.  Marginally lower rates and less aggressive Fed talk should keep the Fed from blowing up this market in the intermediate term.  But if the market rebounds too much, then I can definitely see Powell going back to hawk Powell mode. 

I am seeing a steady flow of elevated ETF put volume relative to calls throughout this week, as investors get more hedged.  We have a big options expiration in 2 weeks, so there will be a lot of put deltas that will either evaporate to 0 if the market goes up or stays still.  Barring nuclear armageddon, dealer hedging flows (delta, vanna, charm) are a net positive for the next 2 weeks, and should provide steady SPX buying, and the flows will be even heavier if the VIX starts to go down. 

Lots of things are in favor of the bulls at the moment, even as it looks scary right now.  Well hedged market, bullish options flows (barring nuclear war), reduced fast money net equity exposure, and lots of fear.  

Given how much fear there is in the market, I expect an extended rally from these levels over the coming months, as investors slowly increase their equity exposure as they put the war behind them and focus on less "scary" things such as inflation and Fed rate hikes.