Wall Street Loads Up on Doom Hedges as Countdown to X-Day Begins

(Bloomberg) — In Washington debt-ceiling brinkmanship is threatening to push the US into default. And on Wall Street, traders are gaming out what could be a rare Black Swan event.

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In the options market, hedges against a volatility breakout are seeing the most demand in five years. The cost to protect against a market selloff of around 10%, or one-standard deviation, is the highest in a year. Demand for tail-risk hedges that pay out in a fall as precipitous as 30%, or three deviations — a Black Swan event — has risen to levels last seen at the peak of March’s banking turmoil.

The doomsday hedging is taking place on the market fringes, against a pervasive calm that’s pushed the widely used Cboe Volatility Index, or VIX, below its one-year average.

Still, veterans warn it may be the calm before the storm, just like in 2011 when few took notice of a funding impasse until the cliff edge of default. JPMorgan Chase & Co. has set up a “war room” looking at contingencies.

In any case, protection against a massive drop is cheap, so people are taking precautions against the unthinkable.

“The demand for both protection from a market downturn as well as tail risk has risen,” said Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets. “Take a look at how VIX did in 2011 leading up to that debt ceiling, it feels remarkably close to today. We are seeing demand for VIX calls because of what happened back then.”

In Washington, the window for averting a potential default is narrowing by the day, and although talks between President Joe Biden and House Speaker Kevin McCarthy yielded little, they are scheduled to meet again on Friday. Treasury Secretary Janet Yellen exhorted leaders to resolve their differences before coffers run dry and the government exhausts its options to fund itself on June 1 — commonly referred to as X-day.

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Back in 2011, a similar standoff triggered an unprecedented credit downgrade of the US government and a 16% drop in the S&P 500 over the span of 10 days, while the VIX climbed to 48. But other deadlines to raise the debt ceiling have come and gone without incident.

Demand for volatility hedges points to turmoil in June — whether from the approach of X-day or from other sources. The level of open interest for call options on the VIX Index recently reached the highest since 2018.

A host of other risks are weighing on markets, from recession to cracks in the banking system to disappointed hopes for a turn to easier monetary policy.

“There are also other actors out there too such as a bad inflation print, strong employment numbers and so on,” said Stephen Crewe, partner at Fulcrum Asset Management. “People don’t really understand why equity markets have been on such a good run with all the bad news out there so they have been buying protection.”

In the meantime, insurance may be the best policy against market resilience that’s become unsettling.

Quant investors known for their quick entry — and exits — have been buying equities on subdued volatility due to strong first-quarter results. They may turn into sellers in a sudden selloff and amplify the downward moves.

A quick reversal would play well for doomsday betters, according to said Maxwell Grinacoff, a strategist at BNP Paribas SA.

“With volatility coming lower, there now is some potential for volatility to actually perform this year,” Grinacoff said.

Another sign that investors are bracing for turmoil can be found in the VVIX, a measure of the volatility of the VIX. The metric has spiked to 99 on strong demand and climbed on Wednesday even as VIX fell.

The divergence is notable because the gauges move together, and may signal rising demand for insurance against debt ceiling turmoil, according to Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.

“There’s more demand for VIX options heading into the debt ceiling issue,” he said “While equity volatility in general is lower the demand for protection against a more extreme tail event remains.”

(updates with JPMorgan “war room” in 4th paragraph, VVIX in 14th paragraph)

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