February was a crazy month where massive volatility was unleashed. With the volatility explosion incident behind us, does that signal the end of this bull market? Our “Phillip Recession Tracker” suggests otherwise where all the indicators are well in the healthy range except for the VIX Index. Overall, the general economic health of US continued to improve in February with no major sign of deterioration.
Figure 1: Phillip Recession Tracker – all remains well
5 February 2018 was the day when the VIX index exploded uncontrollably as it rose 161% from 17.16 to 37.32. This sharp spike was not a complete surprise considering how the market was so extremely positioned on the short volatility trade. The CFTC CBOE VIX Futures Non-Commercial Short Contracts were at a record high of 345,000 contracts, and it stayed extremely short since July 2017. A short squeeze of epic proportion was imminent which eventually happened in early February.
Moreover, some crack signs appeared before the 5 February VIX explosion day. During the last week of January, the VIX index spiked up 39% while the S&P 500 index only experienced a -2% drawdown highlighting something was amiss.
The market only calmed down one day later after the VIX index hit a high of 50.30 on 6 February. As a result, the erratic movements in the VIX index triggered our threshold as it breached above the 27 upper range. Nevertheless, this is only the first warning signal for a more turbulent market ahead. Historically, the S&P 500 index does not top out immediately when the VIX index triggers the upper threshold (27). Instead, we need to see the VIX index going through a period of normalisation first where the VIX index builds a new floor at around the 16.00 level. Once a higher new floor above the complacent 10 floor is achieved, that will signal that the market dynamics have changed to a more fearful tone. Subsequent spikes above the 30 range will signal further flaws and vulnerability in the market.
Figure 2: VIX Index – spiking above the 27.7 upper range
All should remain well until we see further spikes in the VIX index above the 30 range again. In other words, the general equity market should continue to move in the upward trajectory.
The general sentiment of the consumer remains on a euphoria mode despite the Volatility shock. The Bloomberg Consumer Comfort index managed to capture three weeks’ worth of data after the Volatility explosion incident and the consumer sentiment seemed unaffected by it. It continued to linger near the 2001 high at 56.2.
The other two measures of consumer confidence from Conference Board and the University of Michigan showed further improvement in February, highest since 2000 and 2001 respectively. More importantly, as highlighted in the January update, the Umich Consumer Sentiment has rebounded off the key uptrend line threshold and improved to a high of 99.9.
Figure 3: Umich Consumer Sentiment – rebounding off the critical threshold
On the manufacturing front, the ISM Manufacturing PMI improved further to 60.8, the highest level since June 2004. The current level of the PMI remains solid, similar to what the consumer sentiments are displaying.
Interest rate related data
The interbank market started to react to the Volatility shock as the Ted Spread recently crept higher and broke a new 52-week high at 0.41%. Watch this space closely to see if this recent breakout sustains or not. Keep in mind the key threshold to watch for the Ted spread to signal a bear market is the 1% level.
Note: Rising Ted Spread signals increasing stress in the interbank market.
Figure 4: Ted Spread – breaking above the three months range
The 2s10s spread steepened in February, moving further away from the 0% danger zone. This steepening is in line with the expectations of a rate hike in March where the market is already pricing in 100% probability of a rate hike based on the Fed Fund Futures. However, keep in mind that the overall long-term trend in the 2s10s spread is still down. Our base case scenario still points to at least 6 to 8 more months of further flattening before the yield curve inverts.