May 19, 2017 2:40 am JST

Market Scramble: Rising risk augurs index futures landslide

Spike in volatility has potential to trigger automatic sell-off

TAKENORI MIYAMOTO, Nikkei staff writer

TOKYO -- The political storm in Washington is driving up a key measure of market volatility, raising the specter of a massive index futures sell-off that could burn both Japanese and American investors.

The U.S. VIX Index, which gauges the implied volatility of Standard & Poor's 500 composites, jumped 4.9 points on the day Wednesday to 15.59, the biggest jump since Sept. 9. That index climbs when investors see big changes ahead in the market. Just last week, implied volatility recorded a roughly two-decade low, and Japan's own benchmark followed closely.

"For the time being, we have to watch out for a possible landslide," worried one trader at a Japanese securities firm. Open interest in Topix futures among six Western brokerages has reached its highest level since the beginning of 2016, but the spike in volatility could cause this peak to crumble.

The reason why lies in the behavior of certain investors who bought up those futures amid a calm market, including customers at Barclays.

Barclays got out of cash equities trading in Japan in January 2016 and shifted its focus to electronic trading of derivatives, including futures and options. Now "most of its customers are commodity trading advisers and the like, and trade digitally without help from brokerages," surmised a trader at one competing company.

Looking at Barclays' numbers, one can infer that commodity trading advisers had been building up their futures positions until recently. But they are market followers that trade according to price movements, and are known for switching into safe-driving mode and starting to reduce their positions when risk builds.

The practice of diversifying assets with an eye to market volatility is spreading among Western pension funds and other investors as well. Under a risk-parity strategy, such investors automatically sell stocks once volatility crosses a certain line. When commodity trading advisers and risk-parity investors see the VIX rise and swerve into risk-off mode, Japanese equities suffer as well. The global equity rout following China's devaluation of the yuan in August 2015 is seen as partly due to a chain of risk-dodging.

Investors that buy based on economic outlooks and corporate earnings can mitigate the effect of risk-averse mechanical selling. But interest in Japan equities is low, and U.S. investors are looking toward Europe, where inflation is trending upward, says Benjamin Ferguson, head of equities sales at Goldman Sachs Japan.

In the end, the market may have to rely on exchange-traded fund purchases by the Bank of Japan and corporate stock buybacks. Such buying may be able to blunt the effects of a slide, even if the current "Trump shock" spreads. One thing is certain: the Nikkei Stock Average -- which closed down more than 1% at 19,553 -- is headed further away from the 20,000 mark.

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