Backwardation and Bounces

Once again, we see a now-familiar pattern re-emerging.  US index futures sell off sharply overnight, recover somewhat as domestic traders rub the sleep from their eyes to find the “buy” buttons on their screens, then after a bit of nervousness around the open, ever-hopeful dip buyers step in after the initial selling.  Today that is occurring amidst sharp backwardation in both oil and VIX.  It’s easy to note that rallies tend to emerge from the latter condition – the more difficult part is the timing.

Once again, we see the push/pull between the real-world issues causing higher oil prices, inflation concerns, and growth fears versus the undercurrent of FOMO that keeps an underlying bid in US stocks and hence keeps the losses from being catastrophic.  We’ve had a major “black swan” event – the closure of the Straits of Hormuz – but stock markets have barely flinched (SPX -2.2% year-to-date counts as barely flinching) because people remain as focused, if not more, on buying dips and not missing rallies than they are about existential concerns for risk.  FOMO, or “Fear Of Missing Out”, is labeled as fear, but it’s really greed, and I would assert that there is still plenty of greed out there relative to fear.

I offer the following chart as evidence of that premise.  Note that in the six trading days since the Iran conflict began, we have seen stocks bounce sharply off early lows.  The lone exception was Friday, which I described as a decent day, under the circumstances, when traders seemed to think twice about going home with long positions ahead of the weekend.  Note the bounces on the first four days of last week and so far today:

SPX, 6-Days, 2-Minute Candles

Source: Interactive Brokers – Past performance is not indicative of future results.

This morning’s bounce comes alongside some relatively extreme backwardation in oil and volatility.  Backwardation occurs when near-term futures trade with higher prices than those of their longer-term counterparts.  The more normal situation, contango, shows longer-term futures rising relative to shorter-term contracts.  Contango reflects normal conditions of supply and demand, alongside an upward-sloping yield curve.  Backwardation tends to imply a relative shortage of the commodity in question in the near-term, though with conditions improving eventually.

Oil futures are one of the few that typically trade in backwardation.  That is a result of supply conditions and the cost of storage, among other factors.  That said, we have seen oil move into extreme backwardation this week.

Term Structure of Rolling Front-Month WTI Futures, Today (green), 1-Week Ago (red), 1-Month Ago (purple), with Changes vs. Today (bottom)

Source: Bloomberg – Past performance is not indicative of future results.

Note that one month ago, we had a flattish oil futures curve, with modest backwardation in the front, some contango about 5 years out, then a return to backwardation.  We saw that backwardation increase after the start of hostilities and become extreme today – even though we are well off our overnight highs for that product. Importantly, we still see futures markets expecting prices above $70/barrel for several months.  Even a quick end to the closure of the Straits implies that supply headaches could take some time to iron out.

Looking at VIX (Cboe Volatility Index), we see significant backwardation as well.  That implies a shortage of available volatility protection amidst demand from hedgers, with a return to more normal conditions in a few months.  Even so, the curve is quite elevated relative to one-month-ago, and even one-week-ago.

Term Structure of VIX Futures, Today (white), 1-Week Ago (red), 1-Month Ago (purple), with Changes vs. Today (bottom)

Source: Bloomberg – Past performance is not indicative of future results.

Note that VIX is actually down today after flirting with a 30 close on Friday and trading above 35 this morning.  As noted earlier, big rallies often occur after the VIX curve inverts dramatically.  The backwardation is perceived as a bit of panic, and that situation tends to resolve itself eventually.

But when?  Realize that VIX can and does tend to go much higher during crises.  Bearing in mind that the current selloff is barely a blip, let alone a correction or flirtation with bear market levels, we can compare the current state of backwardation with the levels we saw last April in the aftermath of “Liberation Day.”  Stock traders are banking on a quick end to the Iran conflict and reopening of the Straits.  If not, here is the sort of backwardation that could result:

Term Structure of VIX Futures, Today (white), 1-Week Ago (red), 1-Month Ago (purple), April 17^th, 2025 (yellow), April 7^th, 2025 (blue)  with Changes vs. Today (bottom)

Source: Bloomberg – Past performance is not indicative of future results.