By Saqib Iqbal Ahmed
NEW YORK, Sept 9 (Reuters) - With two months until the U.S. midterm elections, the options market is showing a potentially toxic mix of fragility and fearlessness, with some analysts worried markets are ill-prepared to absorb any shock.
Despite recent bond market volatility, stocks remain near record highs, volatility measures are near 2026 lows, and equity market correlations are flirting with record lows, meaning stocks are moving more independently than usual.
While analysts
do not expect the elections themselves to prompt a big market reaction, the run-up to the November 3 vote could be volatile.
As the elections approach, investor focus could turn to the uncertainty over control of Congress and its policy implications — along with the risk of a divided or fragile government — which could stir volatility, analysts said.
Historically, the September-October lead-up to the midterms has been a volatile period for equities as markets exit the typically quiet summer months and investors zero in on political risk.
MARKET CALM
The S&P 500 has dropped 5% or more during the September to October period in 15 of the 24 midterm years since 1930, according to a Cantor Fitzgerald analysis.
But you wouldn't know that from looking at volatility futures.
The options-based investor anxiety gauge, the Cboe Volatility Index, recently touched a new low for the year. At around 15, it is below its long-term median of 17.6. VIX futures also look calm, as investors remain confident strong corporate earnings will continue to support markets.
"The VIX curve is not expressing any premium for midterm elections," said Michael Purves, CEO of Tallbacken Capital Advisors.
A plethora of potential catalysts — including data on inflation and jobs, a Federal Reserve meeting, and a late-September U.S. visit by Chinese President Xi Jinping — fill the calendar over the next two months, culminating in the midterms.
The elections themselves have market implications, some analysts said. The Democratic Party has gained a significant edge over Republicans in voter perceptions of which party has a better approach to the cost of living, a troubling sign for President Donald Trump's party, a Reuters/Ipsos poll found.
Should Democrats wrest control of the House of Representatives, the shift from one-party control of the White House and both chambers of Congress could add uncertainty to markets, Julian Emanuel, lead equity and quantitative strategist at Evercore ISI, said in a note.
"A Senate flip would magnify the dynamic," Emanuel said.
TURBU-LENS
The market's fearlessness combined with an array of sentiment gauges, including crowded positioning, tight credit spreads and limited demand for protection, show the market is ill-prepared to absorb any shock.
"Turbu-lens," a UBS machine-learning framework designed to forecast market vulnerability over the next month, reached the highest level of potential market stress at the end of August.
"It's been basically screaming, extreme fragility for the last several weeks now," said Maxwell Grinacoff, head of U.S. equity derivatives research at UBS.
"If you're driving a go-kart with no seatbelt down the highway at 100 miles an hour, you may get from A to B unscathed ... but if someone hits you, that's not going to be very good," he said.
So far, stocks have been unfazed by increased geopolitical tensions and a bruising bond market selloff, but analysts worry there is little margin for error.
"The system right now is not expecting any kind of shock," said Olivier d'Assier, head of investment decision research for Asia Pacific at SimCorp.
BUSINESS AS USUAL
For some investors, the calm around the midterms seems about right. No matter the results, stocks are likely to remain supported by solid earnings and robust economic growth, they argue.
"The equity market here has been driven by one thing and one thing only, which is earnings," Purves said, noting that midterm results are unlikely to put pressure on earnings or sap demand for stocks.
Moreover, investors who have loaded up on hedges recently have had little to show for them.
"In the last three years, if you shorted the market, you lost money ... so there is also a reluctance to try it again," SimCorp's d'Assier said.
Still, with volatility at current levels, investors looking to guard themselves through the next two months until the elections may find options pricing attractive.
"The overall level of market implied volatility is compellingly cheap when compared to the risks engendered by the midterm elections," Evercore ISI's Emanuel said.
(Reporting by Saqib Iqbal Ahmed; editing by Megan Davies and Rod Nickel)
