In a recent note, Goldman Sachs economist Alec Phillips wonders whether the market is becoming less sensitive to political brinksmanship:
(via Business Insider)
The chart shows the level of VIX in the run-up to the 2011 debt ceiling and 2012 fiscal cliff deadlines. Phillips’s question implies that since VIX was actually lower throughout December 2012, it may be that the market is, in Joe Weisenthal’s phrase, developing an immunity to Washington.
The first problem with this comparison is that the expected worst-case scenarios for the 2011 debt ceiling and 2012 fiscal cliff episodes were very different. The downside risk from a debt default was (and is) expected to be much worse than the 2-4% GDP drag from tax increases and sequestration cuts. Given the different levels of severity, we would actually expect the 2011 debt ceiling implied volatility to be higher, as it is.
Secondly, fiscal issues are never the only thing driving VIX changes at any time, so comparing the VIX time series for these two episodes doesn’t control for all of the other factors affecting expected equity returns in either case.
Finally, the nominal level of VIX is, by itself, meaningless. What if we note that the Deutsche Bank FX volatility index is at 7.88%? Most equity traders don’t pay attention to CVIX, so they won’t have an intuitive sense of what that number is high or low. The only way to form a judgment about whether a given level of implied volatility is extreme or moderate is in relation to the volatility observed in the underlying over the same horizon. There is a quote from Kant that goes something like, “Concepts without percepts are empty; percepts without concepts are blind.” Maybe we could say in this case that implied (volatility) without historical is empty, while historical without implied is blind.
We can make that comparison in the past, but since we don’t know the future, a common practice is to compare current n-day implied volatility with trailing n-day historical volatility. So to make a guess at whether VIX is right or not, traders look at the one-month historical volatility. One way of estimating the volatility risk premium is by looking at this ratio of implied and historical volatility.
The one-month SPX volatility risk premium shows that, to whatever extent fiscal worries have been driving volatility estimates, markets are just as nervous as ever about the potential effects of irresponsible politics. The ratio was actually higher during the month before the 2012 fiscal cliff deadline (red) than during the 2011 debt ceiling episode (black).