Volatility is back on the global markets with a vengeance

The Black Monday of 1987 came two months after the beginning of the term of Alan Greenspan as head of the Federal Reserve. Back then, the Dow Jones Industrial Average (DJIA) fell 508 points, 22.61% below that of the previous trading day.

The new chairman, Jerome Powell, actually is in trouble. On the very day of his swearing in, the American markets crashed without any apparent factor, but amid the increasingly obvious concerns over the evolution of inflation and the interest rates.

After a drop of almost 1,600 points of the DJIA index, in the last trading hour, aggressive buyers miraculously appeared and the index rose about 800 points.

John Crudele writes in the New York Post that "hero" which stopped the crash may have been the President's Working Group for the Financial Markets, created in 1989 by Ronald Reagan, also known as the Plunge Protection Team.

Thus, the first trading day ended with a drop of "just" 1,175.21 the highest in the history of the index, which led to DJIA dropping below its level in the beginning of the year.

The percentage drop was 4.6%, the biggest in the last 6 and a half years. The decline compared to the beginning of the year has been 0.9% for S&P 500 and 1.5% for Dow Jones.

Reuters estimates that the total amount of the losses on the global markets, compared to the price levels from one week ago, amounts to approximately 4 trillion dollars. It is very likely, however, that the Reuters estimate does not include the total effect of the explosion of volatility.

The VIX volatility index, published by the CBOE (Chicago Board Options Exchange), saw on Monday, February 5th, 2018, its highest rise ever, of 115.6%. The VIX quote climbed to 37.32, up from 17.31 on the prior trading day, and on yesterday's opening it rose over 30%.

In the chart of daily rises of the volatility index, the second largest increase occurred on February 27th, 2007, when the VIX rose 64.2%, to 18.31.

The exponential increase in volatility led to the crash of some instruments that allow investors to bet on the drop of the VIX index. The most popular were VelocityShares Daily Inverse VIX Short-Term ETN XIV (XIV) and ProShares Short VIX Short-Term Futures ETF (SVXY), and the combined positions amounted to approximately 4 billion dollars.

The ETN XIV instrument was launched by Credit Suisse in November 2010 and is listed on the NASDAQ. ETN (Exchange Traded Notes) represent debt instruments similar to bonds and are unsecured, as they are usually issued by a financial institution.

The value of a XIV share rose at a rapid pace since mid-2016, when it was priced at 25 dollars, to a high of 115 145 dollars in mid January 2018.

Its crash in the first trading day of the week, followed by a plunge during the trading session to approximately 15 dollars, meant the complete "wipeout" of the gains of the last 5 years within about 2 hours.

During yesterday's opening, the trading of the XIV instrument was halted in wait of information from issuer Credit Suisse, which is being faced with the liquidation of this financial instrument, as the activation of the "termination clause" is imminent.

A CS spokesperson told the Wall Street Journal that "there is no significant impact on the bank", even though the financial institution owns a significant portion of the fund's shares.

The drop in volatility to historic lows last year, amid the suppressing of the price signals by the major central banks, has led to an 187% rise of the XIV in 2017 and 180% of that of the SVXY. The XIV instrument drew additional investments of approximately 750 million dollars since the beginning of the year alone, according to data by Bloomberg.

According to analysts quoted by Wall Street Journal, "the sudden disappearance of instruments that are based on volatility will lead to chain losses for investors and will lead to the amplification of moves on the futures markets".

"There is such an active market for volatility instruments that volatility can determine the overall direction of markets", Luke Oliver, an executive with Deutsche Asset Management told Bloomberg.

Precisely for that reason, "the speed of the market's drop was frightening", according to Walter Hellwig, the vice-president of BB&T Wealth Management. According to Hellwig, the drop in the first part of the trading session of February 5th, 2018 has been caused by the sales of traders and brokers, and the crash in the second half was fueled by algorithmic trading.

What is next?

Peter Schiff, CEO of Euro Pacific Capital, said in an interview with website The Street, that a potential "secret wish of the Federal Reserve to see massive market drops needs to be seen as a possibility", with "the blame being laid on president Trump".

In a few days the Federal Reserve will make its first "move" with the new chairman Jerome Powell.

Regardless of its nature, investors need to be prepared for markets where volatility has broken its chains and is back with a vengeance.