Federal Reserve Bank’s “Whatever it Takes” Response Impacts U.S. Small-Caps

In an effort to impede the further spread of the novel coronavirus (COVID-19), decisions were made to shudder “non-essential” workplaces pushing millions into the unemployment system that wreaked havoc on a wide swath of American businesses. 

The U.S. stock market’s subsequent sell-off arguably impacted the Federal Reserve Bank’s (FRB) decision to make the following announcement on March 23 stating that it was ”…committed to using its full range of tools to support households, businesses and the U.S. economy overall.” To restore confidence, FRB modified its Global Financial Crisis playbook and pledged to buy investment grade and high-yield U.S corporate debt in addition to other usual debt instrument purchases. On April 9, FRB introduced Secondary Market Corporate Credit Facilities (SMCCF), a program with the ability to purchase up to $750 billion worth of investment grade and high yield corporate bonds, including ETFs.

Russell 2000 Index (RUT℠) vs. Bloomberg Barclays High Yield Corporate Bond Option Adjusted Spread:

FBR’s willingness to purchase U.S. corporate debt was considered a crucial lifeline to companies that needed to raise cash or refinance their debt. This action stood to benefit particularly small-cap companies that are typically highly leveraged using the high yield credit market to access their financing. As a measurement of demand for high-yield corporate bonds, the Bloomberg Barclays High Yield Corporate Bond Option Adjusted Spread (OAS) (Green Line) and its inverse relationship to the Russell 2000 Index has been used by some investors as a good leading indicator for the Russell 2000 Index (White Line).

Source: Bloomberg

U.S. Small-Cap Rotation:

The Fed’s actions encouraged investors looking for an early cycle economic recovery and led to a rotation into U.S. Small-Caps. The Russell 2000 Index was hit particularly hard during the acute selloff. The small-caps declined by 43% compared to their large-cap counterparts (Russell 1000 or S&P 500) which fell by approximately 35%. With the Russell 2000 outperforming the S&P 500 over the past two months, investors may be expecting an early cycle recovery. The S&P 500 and Russell 2000 Indexes both bottomed on March 23 (2191.86 and 966.22 respectively). Since that date, the Russell 2000 has gained 44.96% and the S&P 500 is up by 38.22%. (See graph below)

Large-Cap vs Small-Cap Relative Volatility Dispersion:

Higher risks are typically associated with small-cap companies -- lower liquidity, debt leverage and higher defaults contribute to the Russell 2000 Index risk premium over the S&P 500 Index. Consequently, the Russell 2000 Index options (RUT℠) historically exhibit an implied volatility (IV) risk premium over the options on the S&P 500 Index (SPX).

Using Cboe’s benchmarks on the 30-day expected volatility on the S&P 500 (VIX™) and Russell 2000 (RVX™), the RVX Index on average has a +3.40 implied risk premium over VIX Index. On March 16, the relative values between the RVX and VIX Indexes widened to a record level of 16.26. The subsequent rally in both large-cap and small-cap stocks created a divergence between volatility levels in the RVX Index and VIX Index that remains historically wide, measuring 11.65.

Source: Bloomberg

Relative Value Volatility Spread (RUT℠ vs. SPX)

As mentioned, both large and small-cap equity indexes have rallied over the last two months. Forward looking volatility measures have abated, but implied volatility levels for the small-cap Russell 2000 Index (RVX) remain high relative to the same measure of large caps (VIX).

Divergences of this type may present an opportunity. In this case, the potential IV narrowing (compression) between RUT℠ 1-month options and SPX 1-month options. We are most certainly not in the trade recommendation business, but straddle and strangle swaps may be one way to express a relative IV sentiment as opposed to an overtly directional macro position as seen in the illustration below:

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^{The information in this blog post is provided for general education and information purposes only. No statements within this blog post should be construed as a recommendation to buy or sell a security [or futures contract, as applicable] or to provide investment advice. Supporting documentation for any claims, comparisons, statistics or other technical data in this blog post is available by contacting Cboe Global Markets at www.cboe.com/Contact. Past Performance is not indicative of future results. [Applicable Cboe, VIX and RVX are registered trademarks of Cboe Exchange, Inc.}  

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