Vix, Chix, fat fingers and the return of fear

PUBLISHED : Monday, 10 May, 2010, 12:00am
UPDATED : Monday, 10 May, 2010, 12:00am

Not since March last year, during the depths of the financial crisis, have markets begun a week in a mood of such fear and uncertainty.

That's not just vacuous columnist's babble. It's a measurable phenomenon.

The first chart below shows the Vix index of US stock market volatility. Derived from the implied volatility of S&P 500 index options traded on the Chicago Board Options Exchange, the Vix has been aptly dubbed 'the fear gauge'. The lower the index level, the keener investors' appetite for risk; the higher the index, the greater their risk aversion.

As the chart shows, last week risk aversion shot higher, with the Vix hitting levels not seen since March 2009, when the US stock market slumped to its lowest level in 13 years.

Sure, a lot of that spike upward in the Vix was the result of the US market's spasm on Thursday, when the S&P 500 crashed 6 per cent in a matter of minutes before rebounding just as quickly.

The exact cause of the sudden sell-off remains a mystery. But inquiries are focusing on algorithm-driven high-frequency traders.

Algorithmic, or algo, trading was originally developed to allow large institutions to work big orders through the market. A computer program would slice the order up into small lots and submit them one by one in order to minimise the impact on the market price.

With the development of ever more sophisticated technology, however, algo trading was adopted by specialist hedge funds who employed computer programs to execute millions of trades via automated dealing systems, often dipping into and out of the market in thousandths, or even millionths, of a second to exploit tiny pricing anomalies. Critics have long argued that the rise of these high-frequency traders threatens to exacerbate market volatility, and what happened on Thursday appears to prove their fears justified.

In all probability, human error was initially to blame. Perhaps a dealer accidentally keyed in 'billion' rather than 'million' in a 'fat finger' trade. But whatever the precise trigger, automated systems seized on the mistake immediately, whipsawing the market back and forth with unprecedented savagery.

But although Thursday's short-lived crash accounts for some of the surge last week in the fear gauge, it is by no means the whole story. After all, Hong Kong was not directly affected by Thursday's sneeze, which happened in the small hours of the morning local time, yet the Chix index, the Hong Kong market's very own fear gauge, also shot up sharply last week, reaching its highest level since last summer.

Fears over the sustainability of China's credit- and investment-driven growth model have something to do with that, coupled with contrasting worries that Beijing may be in danger of stamping too hard on the economic brakes.

But the main reason for investors' heightened fear is the continuing sovereign debt crisis in Greece and the concern that the turmoil may spread by contagion to the euro zone's other highly indebted economies.

That would cause havoc for Europe's banks, which are big holders of euro-zone government debt. The second chart below depicts the cost of insuring against a default by Germany's Commerzbank or Spain's Banco Santander through the five-year credit default swap market. It shows clearly that for some European banks, sentiment is worse now than at any time during the 2008-2009 credit crisis.

In other words, the crisis is still going on and is in danger of getting even more severe.

And it continues to affect Asia. Last week a clutch of stock offerings was aborted because of market volatility. Stock and commodity prices slumped as investors pulled money out of risky assets, and currency markets went haywire. The Indonesian rupiah, for example, dropped more than 2 per cent against the US dollar on Thursday.

As a result of the mayhem, economists are expecting Asian central banks to delay planned interest rate increases. And with the Chinese currency up 2 per cent over the last four weeks on a trade-weighted basis, thanks largely to the weakness of the euro, Beijing is likely to put on hold any plans to revalue the yuan. This is not the time for disruptive policy moves.