Analysis-Hawkish Fed could hobble volatility funds’ stock buying spree
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By Saqib Iqbal Ahmed
NEW YORK (Reuters) – Volatility-linked funds, which are estimated to be buying up to $2 billion in U.S. stocks a day, are helping drive this year’s stock recovery and could add to buying in the coming weeks , although a restrictive Federal Reserve could spoil the party.
The S&P 500’s 6.2% gain in January was accompanied by a general decline in volatility measures. The index’s daily fluctuations over the past month have been the smallest since early 2022, while the Cboe volatility index is also near a one-year low.
The decline in market action has triggered a buy signal for certain computerized strategies, including volatility control funds, risk parity funds and commodity trading advisors (CTAs).
GRAPH: Decrease in volatility https://www.reuters.com/graphics/USA-STOCKS/gdvzqdqdxpw/chart.png
These funds, commonly known as systematic strategies, have been raising between $1 billion and $2 billion a day in U.S. stocks, according to BNP Paribas estimates, and helping fuel a stock rally that has continued despite fears that a dovish Fed could disrupt the US economy could plunge, recession has occurred.
“This was definitely more of a flow-driven rally than a shift in the broader fundamental backdrop,” said Max Grinacoff, US equities and derivatives strategist at BNP Paribas.
Grinacoff estimates that if realized volatility — a measure of daily stock fluctuations — halves from its current level of about 16%, this type of fund could commit another $50 billion to $60 billion in additional purchases over the course of a month Level of calm not seen in US stocks since late 2021.
Of course, the market has a plethora of risks to contend with, most notably the Fed, which concludes its monetary policy meeting on Wednesday. Signs that the central bank is unlikely to reverse its tightening monetary policy outlook despite signs of easing inflation and a weak economy could heighten recession fears and reignite volatility, forcing funds to scale back purchases or even ramp up sales begin.
Markets generally expect the central bank to hike borrowing costs another 25 basis points to between 4.50% and 4.75%.
Other potential pitfalls include this week’s earnings from some of the largest US companies, including Apple Inc, Alphabet Inc and Meta Platforms Inc, as well as the closely-watched US Nonfarm Payrolls report on Friday.
“As we believe that technical factors may have played a large role in market performance so far this year, we expect this to fade at some point as fundamental factors regain the dominant position as market drivers,” Mark Haefele, chief investment officer at UBS Global Wealth Management said in a note on Tuesday.
Investors said conditions were favorable for a rally earlier in the year. The S&P 500’s 19.4% decline last year, its sharpest annual percentage decline since 2008, had prompted market participants – including various volatility-linked strategies – to reduce their equity allocations to historically low levels.
“We have this trifecta of seemingly depressed equity positioning across three broad investor groups: vol target funds, CTAs and hedge funds,” said Anand Omprakash, head of quantitative strategy for derivatives at Elevation Securities.
Volatility control funds have increased their equity exposure to a nine-month high of 57.7%, Deutsche Bank strategists wrote on Friday.
BNP Paribas’ Grinacoff estimates that volatility control funds have around $275 billion in assets, while CTAs, who do not all have a volatility control strategy, as a group have $800 billion spread across all strategies.
While that’s modest compared to the S&P 500’s roughly $34 trillion worth, such funds should be watched for as they buy in rising markets and sell when stocks are falling, potentially exacerbating downsides and rallies .
Although volatility has fallen off last year’s highs, when the VIX rose to 36.55, current levels remain above the index’s long-term average, a sign that options investors are likely considering the risks ahead, Garrett DeSimone said. Head of Quantitative Research at OptionMetrics.
“Market volatility as measured by the VIX remains above the 18 level, the long-term average. This suggests a slight concern about the macroeconomic outcomes of future volatility,” he said.
(Reporting by Saqib Iqbal Ahmed in New York; Editing by Ira Iosebashvili and Matthew Lewis)