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The Fed is worried about a key measure in the stock market

Frank Chaparro
janet yellen

(Janet L. Yellen, Chair, Board of Governors of the Federal Reserve System, looks over her notes as she testifies before the United States Senate Committee on Banking, Housing,

  • The Federal Reserve said January 22 it is worried about the "low level of implied volatility in equity markets"
  • The VIX, a gauge of market fearfulness, has been bouncing around at historic lows
  • That seems at odds with the "considerable uncertainty" the Fed expects in US policy

The Federal Reserve is worried that the stock market might be showing signs of complacency. 

The central bank's most recent communication  the Fed minutes for the January/February meeting  released on January 22 shows that members are split on whether President Trump's agenda will spur economic growth.

That uncertainty doesn't seem to be showing up in the stock market, however. The Chicago Board Options Exchange volatility index, which gauges investor anxiety (technically, implied expectations for volatility in the stock market) and is widely known as the VIX index, has been trending down. 

The Fed minutes said: "They also expressed concern that the low level of implied volatility in equity markets appeared inconsistent with the considerable uncertainty attending the outlook for such policy initiatives."

What is implied volatility, and why is it so low?

The VIX is commonly read as a gauge of market fearfulness, and measures the market's expectation of volatility implicit in the price of options on the Standard & Poor's 500.

One way to think of it is like the cost of an insurance policy. When the market is expected to be volatile, there are more buyers of insurance, and so the cost of that insurance rises. When the market is relaxed, nobody's interested in buying insurance against a wild swing, so the protection offered by options is inexpensive. 

Lately, the VIX has barely been moving, only breaking 20 on a handful of occasions, and generally trending below 13.

Screen Shot 2017 02 24 at 5.41.06 PM

(Markets Insider)

"The reason the VIX has been so low over the last several weeks is simply because the S&P 500 has experienced practically NO downside volatility in months and the VIX is a reflection of that," Andrew Adams, a market strategist at Raymond James, wrote in an email. "The index has still not fallen more than 2% at any point since the election and has not really struggled since the brief Brexit scare. So, naturally, the VIX is going to be low since it’s simply confirming there has been no downside in quite a while."

There are technical reasons for the low levels of implied volatility, too. Remember that insurance analogy? Right now, writing, or selling insurance, looks attractive. That is driving the price of those insurance policies down. 

"Lately it hasn’t paid to be long on the VIX, as it has been flat," J.J. Kinahan, chief market strategist at TD Ameritrade, told Business Insider. "Those who are buying protection in the SPX [the S&P 500] are investors willing to give up some upside to protect the downside, that is, they’re selling out-of-the-money calls to purchase out-of-the-money puts." 

Selling insurance has the potential to backfire, of course. Goldman Sachs strategists said in early February that VIX short positioning, or bets against volatility, have increased to high levels. That "can drive a sharp reversal in the event of a VIX spike," Goldman Sachs said.

That's likely the cause of the Fed's concern, according to Kinahan. He said the reason why the Fed is worried about the VIX is so low, is because they don't want to see a dramatic spike up. 

"Because that would go hand and hand with a market sell off," he said. 

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