What's interesting to note is that much of the 'valuation gap' between the SPX and the VIX appears to have vanished (in favour of the VIX, of course.) Might this mean that the market is no longer overweight downside, and thus more vulnerable to a steep correction? The 1487 double top neckline should provide critical clues. Whether that level breaks or holds, and whether such action is sustained, could well depend on whether the FOMC sends an overtly dovish or hawkish message tomorrow night.
Market focus remains on the swirling subprime issue and the potential for mark-to-market shockers as we end the quarter. What's interesting is that, as one might suspect given market correlations over the past year, most measures of volatility have risen substantially. VIX, MOVE, and credit spread indices are all back at or near their highs of February/March. One exception is USD/JPY vol, which has lagged markedly despite the historically strong correlation. While the chart below compares USD/JPY 3 month implied vol with the VIX, rest assured that MOVE, crossover, and ABX indices all look a lot more like the white line than the green one.
This is particularly interesting given the personnel change at the MOF and the apparent shift in Japan's laissez-faire attitute towards yen weakness. Macro Man opined yesterday that while such a shift might not alter the destination of the yen, it should alter the path of the yen, introducing more volatile, two-way price action. Given that yen vol has lagged other risk measures, and that there are some Japan-specific reasons to expect volatility to rise, and moreover that some of the yen crosses are starting to approach levels that might kick off CTA liquidation, the investment conclusion is fairly obvious. Macro Man therefore buys $25 million/leg of 6 month 120 straddles (7.5% vol) to go long volatility in the cheapest risk hedge going.
Yesterday's profit-take on the FX carry basket was exceptionally serendipitous, but underscores the value of a beta-plus, rather than simply beta, portfolio. Introducing a filter that only implements the beta position when underlying conditions are favourable can substantially improve investment performance; the FX carry position provides an extremely fortunately-timed example of how.