Is the Equity Market On Thin Ice? VIX Term Structure Sheds Light On Looming Risks

As the market grapples with potential near-term bullish drivers, one key indicator of downside pressure has awakened after a prolonged pause. The CBOE Volatility Index, often referred to as the "fear index", gauges the anticipated volatility of the S&P 500 index over the ensuing 30 days. While we've observed its rise in recent sessions, VIX futures currently suggest a state known as backwardation taking place, highlighting the market's immediate concerns.

Background

While we won't delve deep into the intricacies of the volatility index's calculations, it's crucial to understand that this index evaluates the premiums priced into both call and put options. As market uncertainty grows, market makers hike premiums to counter unpredictable risks. Consequently, as these premiums rise, so does the VIX. VIX futures, another instrument tradable on the CME, enable traders to predict the VIX's future values.

In general, the greater the duration, the higher the uncertainty surrounding potential market-impacting events. Hence, we typically see short-term contracts priced lower than their long-term counterparts. This situation is technically termed as Contango. Simply put, more time equates to greater uncertainty.

Conversely, backwardation occurs when short-term contracts command higher prices than their longer-dated counterparts. This pattern underscores immediate market uncertainties, signaling potential market volatility. On October 3rd, the VIX term structure entered backwardation.

While this phenomenon doesn't signal impending doom, traders must recognize the market's current vulnerability. Such fragility can lead to decreased liquidity, creating further volatility.

However, this backwardation can also lead to positive developments. Typically, the market often restores the VIX curve, potentially setting the stage for a subsequent broader equity surge. It's noteworthy that when the VIX surpasses the front futures VIX Futures contract, it usually returns to normalcy within a week.

The Wrap

The market might persist in this backwardation phase until the release of the Non-Farm Payroll numbers on Friday. These figures will offer a clearer glimpse into the labor market, which has consistently been one of the market's stronger segments. If this economic data outperforms expectations, it could act as a "springboard" for equity markets, with traders lifting their portfolio hedges and market makers reducing downside pressures. Conversely, if the data continues to paint a bleak future, the backwardation trend might intensify.