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Equities Storm Looking Overblown as Volatility Gauge Stays Calm

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(Bloomberg) -- Wall Street’s fear gauge is relatively sleepy after Monday’s stock rout, prompting some strategists to play down fears that stagflation and the debt-ceiling battle will set off a steep correction.

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The Cboe Volatility Index, or VIX, closed at 22.96 on Monday, close to its lifetime average of 19.5. More notably, its term structure shows expectations of increased volatility further out in the future rather than close in, signaling relative calm.

“When the VIX spikes and when the VIX term structure inverts, we know markets are bracing for large near-term volatility events,” Fundstrat strategists including Tom Lee wrote in a report Monday. “Stocks might be over-reacting” to some of the negative drivers out there, including the debt-deadline issue, they wrote.

The S&P 500 is down 5.2% from its early-September record. The drop came as U.S. yields rose with the Federal Reserve talking about tapering stimulus, and as supply-chain woes underscore concerns inflation will remain elevated. President Joe Biden’s warning that the U.S. government is at risk of breaching the legal limit on its debt in two weeks is also a key risk.

If the debt ceiling is at risk of being breached, the one-month VIX future should exceed the four-month contract -- but it isn’t -- signaling a ‘buyers strike’ for stocks might end sooner rather than later, Fundstrat said.

Credit Suisse AG also says the VIX is signaling a lack of sharp concerns, arguing investors may have already hedged pretty well into the declines.

“A lot of downside risks have already been priced into the volatility surface, and thus the hurdle to get a real vol move is much higher,” Credit Suisse strategists led by Mandy Xu wrote in a note Monday. They recommend put-option spreads as a way to take advantage of steep skew, a situation where bearish options are relatively expensive compared with bullish ones.

Susequehanna, on the other hand, sees the calm as a potential signal that stock investors aren’t actually very worried about an increase in Treasury yields -- which aren’t all that high relative to long-term norms.

“It seems like the volatility markets are getting more comfortable and less surprised by the UST-yield induced turmoil,” Susquehanna derivatives strategist Chris Murphy wrote. “Investors might be expecting more choppiness but not any additional tail risk as investors adjust to a ‘return to normal’ for UST yields.”

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