Possible Shutdown, Yellen And Volatility
Summary An update on the current volatility landscape. Possible backwardation scenarios. A look at how previous events have effected UVXY. There has been talk, from both sides of a government shutdown. This article will look back on the recent shutdown and how that effected volatility. For the basis of discussion, we will use the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ). We will also examine the recent Federal Reserve commentary and how that could also affect December volatility. Previous Shutdown The last time the U.S. government shutdown was on October 1, 2013. In the history of the U.S. there have been several funding gaps and government shutdowns due to issues from abortion, the budget deficit, health care, and general political showmanship. In the weeks leading up to the last shutdown the front month VIX futures contract traded between $14-$15 (it currently trades around $18), roughly speaking. It climbed and peaked at a closing price of $19.40 on October 8, 2013. In the weeks following the resolution front month futures quickly settled back to the $14-$15 area. See below for a charts on how UVXY reacted during the 2013 shutdown: (click to enlarge) Current Situation One important fact to note is that 2016 is an election year. 2013 was the year after an election year. Bold and risky political decisions are usually made when the repercussions have more distant consequences. I believe the current situation is nothing more than the political showmanship and bickering that we have seen over the past decade. In the end there will probably be a last minute deal that doesn’t solve any of the real problems and kicks the can down the road for someone else to take care of. The Federal Reserve Janet Yellen has single-handedly been volatility’s best friend the last several years, with one exception. That exception was the August meeting where markets were expecting a signal on rate increases and nothing happened. Why would Janet do this? She knew that’s what the market wanted and has followed their demands for so long that it should have been a no-brainer (satire). This spooked the markets and caused a major spike in volatility which hadn’t previously been seen since 2011. At the September meeting nothing happened again and there was another small increase in volatility. Markets were spooked because they now view the Federal Reserve rate increases as a predictor for the strength of the economy. If the economy was healthy and inflation was expanding at a more robust pace, rates would already have been raised. However, time after time global economic weakness and slack in the labor market continue to be cited as cause for concern. See below for the UVXY reaction during those events: Conclusion We once again approach a potential, but unlikely, government shutdown at the end of next week. After that Yellen is back up to deliver the final bit of big news before Christmas. Will Yellen be naughty or nice to the markets? I am focused on a 0.25% increase in rates and Yellen’s comments on the overall economy. Markets will be focused on comments relating to the pace of future increases. If you are a regular reader, we discussed an increase in volatility throughout the second half of 2015 and into 2016. We certainly have seen that uptick and I continue to expect increased volatility levels due to the level of uncertainty in the markets. There are currently many unanswered questions about the economy and what I view as the new normal of slow growth. Job growth continues on its positive track and has been the bright spot in the overall economy. I am working on a very interesting piece that focuses on the psychology behind volatility and how irrational moves by others can make rational gains for your investment account by using volatility ETFs such as UVXY. For more information about UVXY, I recommend viewing this article that gives a beginners guide to the unleveraged version of UVXY, which is the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ). We have two more weeks until school is out for break and I look forward to relaxing with family. I hope you have the opportunity to as well and wish your family a very happy and prosperous holiday season and new year. My current advice is to stay patient and up to date with current events. Keep a keen eye on U.S. economic indicators heading into 2016. It wouldn’t take much to move this economy into negative territory which creates perfect opportunities for exaggerated irrational behavior. It is a risky time to be involved with both inverse and long volatility products such as UVXY. I would remain on the sidelines and wait for a clearer opportunity of shorting volatility to present itself (for more information on my theory of only shorting volatility and when to do it, view this article ). If backwardation levels rise over 5%, then I will begin to pay attention to what is happening. Ultimately in this environment I would expect a maximum backwardation event of around 20% (excluding a war). Let August be your guide as to how quickly this market will hit the panic button. For now just sit back, relax, and don’t do anything greedy until the right opportunity presents itself. As always, thank you so much for reading and we will speak again soon.