NEW YORK, Feb 1 (Reuters) – Volatility-linked funds
estimated to be buying as much as $2 billion in U.S. equities
daily are helping drive this year’s rebound in stocks and may
ramp up purchases in coming weeks, though a hawkish Federal
Reserve could spoil the party.
The S&P 500s 6.2% surge in January has been
accompanied by a drop in measures of volatility across the
board. Daily swings in the index over the past month were the
smallest since early 2022, while the Cboe Volatility Index
also stands near a one-year low.
The drop in market gyrations has triggered a buy-signal for
certain computer-driven strategies including volatility control
funds, risk parity funds and Commodity Trading Advisors (CTAs).
Broadly known as systematic strategies, these funds have
been scooping up between $1 billion and $2 billion a day in U.S.
stocks, according to BNP Paribas estimates, helping drive an
equity rally that has come despite worries that a hawkish Fed
will plunge the U.S. economy into recession.
“This has definitely been more a flow-driven rally than a
shift in the overall fundamental backdrop,” said Max Grinacoff,
U.S. equity and derivatives strategist at BNP Paribas.
Grinacoff estimates these types of funds could deploy
another $50 billion-$60 billion of additional buying over the
course of a month if realized volatility – a measure of daily
stock swings – halves from its current level of around 16%, a
level of calm unseen in U.S. stocks since late 2021.
Of course, the market will have to navigate a plethora of
risks ahead – most prominently the Fed, which concludes its
monetary policy meeting on Wednesday. Signs that the central
bank is unlikely to pull back on its hawkish monetary policy
outlook despite evidence of slowing inflation and softness in
the economy could exacerbate recession fears and reignite
volatility, forcing the funds to taper purchases or even start
selling.
Markets widely expect the central bank to raise borrowing
costs by another 25 basis points to between 4.50% and 4.75%.
Other potential pitfalls include earnings from some of the
largest U.S. companies this week, including Apple Inc,
Alphabet Inc and Meta Platforms Inc, as well
as the closely watched U.S. nonfarm payrolls report on Friday.
“As we think that technical factors may have played a large
role in the market performance so far this year, we expect this
to eventually wane as fundamental factors resume the dominant
position as market drivers,” Mark Haefele, chief investment
officer at UBS Global Wealth Management, said in a note on
Tuesday.
FAVORABLE CONDITIONS
Investors said conditions were supportive of a rally at the
beginning of the year. The S&P 500’s 19.4% drop last year, its
worst annual percentage decline since 2008, had prompted market
participants – including various volatility-linked strategies –
to cut their equity allocations to historically low levels.
“We have this trifecta of seemingly depressed equity
positioning across three major investor groups: vol target
funds, CTAs and hedge funds,” said Anand Omprakash, head of
derivatives quantitative strategy at Elevation Securities.
Volatility control funds have raised their equity allocation
to a nine-month high of 57.7%, strategists at Deutsche Bank
wrote on Friday.
Grinacoff, of BNP Paribas, estimates volatility control
funds have assets of about $275 billion, while CTAs, not all of
which have a volatility control strategy, as a group have $800
billion allocated across strategies.
While that is modest relative to the roughly $34 trillion
value of the S&P 500 alone, such funds bear watching since they
buy in rising markets and sell when stocks tumble, and can
potentially exacerbate downside moves as well as rallies.
To be sure, while volatility has fallen from last years
peaks, when the VIX rose as high as 36.55, current levels remain
above the indexs long-term average, a sign that options
investors are likely mindful of the risks ahead, said Garrett
DeSimone, head of quantitative research at OptionMetrics.
“Market volatility measured by VIX remains stuck above the
18 level, which is its long-term average. This indicates a
slight anxiety regarding macro outcomes on future volatility,”
he said.
(Reporting by Saqib Iqbal Ahmed in New York
Editing by Ira Iosebashvili and Matthew Lewis)
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