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Investors Load up on Debt Ceiling Doomsday Scenario Hedges Pointing to Market Turmoil

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Analysts Notebook wrote a column · May 12, 2023 11:43
In Washington debt-ceiling brinkmanship is threatening to push the US into default. And on Wall Street, traders are gaming out what could be a rare Black Swan event with the well known fear gauge.
Demand for hedges against a sudden increase in volatility has reached its highest level in five years in the options market. Investors are paying more to protect themselves against a potential market drop of 10% (one-standard deviation), which is currently at its highest cost in a year. There has also been increased demand for tail-risk hedges, which can pay out in the event of a significant market crash of up to 30% (three deviations) - a rare and unexpected event referred to as a Black Swan. The current demand levels for such hedges have not been seen since March's banking turmoil.
Despite the widespread calm in the market, investors are still engaging in doomsday hedging, albeit on the market fringes. This is evident by the high demand for hedges against an increase in volatility, despite the widely used $CBOE Volatility S&P 500 Index (.VIX.US)$ being below its one-year average.
Despite the current calm in the market, experienced investors are warning that it could be a precursor to a storm, similar to what happened in 2011. Back then, few took notice of a funding impasse until the last minute when the threat of default loomed large.JPMorgan Chase & Co. has set up a “war room” looking at contingencies.
The demand for both protection from a market downturn as well as tail risk has risen,” said Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets. “Take a look at how VIX did in 2011 leading up to that debt ceiling, it feels remarkably close to today. We are seeing demand for VIX calls because of what happened back then.”
Source: Bloomberg
Source: Bloomberg
In Washington, the window for averting a potential default is narrowing by the day, and although talks between President Joe Biden and House Speaker Kevin McCarthy yielded little, they are scheduled to meet again on Friday. Treasury Secretary Janet Yellen exhorted leaders to resolve their differences before coffers run dry and the government exhausts its options to fund itself on June 1 — commonly referred to as X-day.
Back in 2011, a similar standoff triggered an unprecedented credit downgrade of the US government and a 16% drop in the S&P 500 over the span of 10 days, while the VIX climbed to 48. But other deadlines to raise the debt ceiling have come and gone without incident
Demand for volatility hedges points to turmoil in June — whether from the approach of X-day or from other sources. The level of open interest for call options on the VIX Index recently reached the highest since 2018.
Source: Bloomberg
Source: Bloomberg
There are also other actors out there too such as a bad inflation print, strong employment numbers and so on,” said Stephen Crewe, partner at Fulcrum Asset Management. “People don’t really understand why equity markets have been on such a good run with all the bad news out there so they have been buying protection.”
Source: Bloomberg
Disclaimer: This presentation is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. It is provided without respect to individual investors' financial sophistication, financial situation, investment objectives, investing time horizon, or risk tolerance. You should consider the appropriateness of this information having regard to your relevant personal circumstances before making any investment decisions. Past investment performance does not indicate or guarantee future success.
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