vix and csfb divergence will not last

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By :  ,  Financial Analyst

The S&P 500 has risen to a fresh record high on Thursday, and the Vix index has dipped below 10.00, as the risk rally marches on for another day. When volatility is this low there is always some latent panic in the market – how long can the Vix stay this low for? Is it time for the Vix to bounce, and what will that mean for stocks?

The answer is that the Vix can stay low for some time, but when it pops higher it can cause a hefty sell off for stock markets and other risky assets. The trillion dollar question now is, when will the Vix pop higher?

Our crystal ball here at City Index tends to get a little cloudy, so we can’t promise to pinpoint this with any accuracy, however, there is one relationship that we would like to explore that could be a warning sign for those basking in the glow of a single digit Vix index.

Why the Vix could be at risk

The chart below shows the Vix and the Credit Suisse Fear Barometer (CSFB), this chart has been normalised to show how they move together. The Vix measures the price of 30-day volatility for the S&P 500, while the CSFB measures the cost of buying protection against declines in the S&P 500. As you can see, the Vix and the CSFB tend to move together over time. However, there have been instances in the past year when they have diverged, and we have seen this happen once again since the start of May. The Vix is falling, which suggests lower volatility, while the CSFB remains elevated, suggesting that panic in the market is also rising at the same time. So, which indicator is correct?

What is interesting to note is that there tends to be a strong mean-reversion tendency for these two indices, suggesting that after periods of divergence they will move back in line with each other. Thus, if you think that a sub-10 level for the Vix is underestimating current market risk, then the CSFB could be a precursor for more volatility ahead. If this happens then it could be the summer of discontent for risky asset prices.

Of course, one could also argue that a sub-10 level for the Vix is a reason for people to buy protection against a decline in the S&P 500, which may not be captured by the Vix index, but will push the CFSB higher. However, whichever way you look at it, this chart suggests that a divergence between the Vix and the CSFB is unlikely to last in the long-term, so watch this chart to find out where stock markets could be heading in the future.

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