The implied volatility in equity, bonds and currency markets has declined across the board, with the average now falling below its previous low in February 2007. In other words, investors attach a low probability to significant price swings in the short term.
The drop in market volatility has coincided with the search for yield; equities paying high dividends have beaten the benchmark by 10 per cent since 2009 and yields on speculative-grade corporate bonds have fallen to all-time lows. Investors are also flocking to some of the riskiest frontier market bonds and the carry trade in the currency market is in full swing.
At the same time, low volatility has encouraged investors to leverage their bets — New York Stock Exchange broker margin accounts as a share of market cap have risen to levels last seen in 2000.
Low volatility in itself does not necessarily give cause for concern. Indeed, in many ways, the drop in volatility can be justified by structural changes in the economic and investment landscape.
We think this current phase of low volatility stems from a combination of low macro-economic volatility, expectations that central banks will keep interest rates low for longer and shifts in the behaviour of investors.
In the US, macro-economic volatility — measured by how key economic variables like inflation, interest rates and business surveys have deviated from their average readings over a rolling two-year period — has fallen to a record low in the second quarter. Lower macro-economic volatility translates into a higher predictability of asset cash flow for investors and, in turn, into lower asset price volatility.
Low macro-economic volatility also reduces the scope for the risk-on/risk-off trade. When economic conditions are perceived to be more stable, company-specific factors such as earnings prospects and corporate actions (for instance, mergers and acquisitions) become more important drivers of stock performance.
This reduces the correlation of returns among individual stocks, and dampens the volatility of market indices. According to our calculations, a proxy for the correlation within the S & P500 and Eurostoxx indices is almost half the average of the past five years.
Another key reason
The dovish forward guidance by major central banks is another key reason for low market volatility. The US Federal Reserve has assured investors that it is in no hurry to raise interest rates, even though it is withdrawing monetary stimulus. Central banks in the euro zone and Japan are also expected to keep ultra-loose monetary policy for an extended period.
Increased transparency by rate setters can reduce the uncertainty over the future path of interest rates, i.e. the discount rate of future cashflows.
Additionally, the use of macro-prudential measures — the new architecture designed by central banks to mitigate risks in the financial system — along with traditional monetary tools has the potential to further reduce the volatility of the credit and economic cycle.
The changing nature of the investor base could also be a factor behind lower observed market price volatility. Over the past 20 years, the flows into equity mutual funds have become more stable, possibly as a consequence of the growing importance of retirement plans.
As these plans typically maintain a constant asset allocation, they tend to buy in falling markets and sell in rising ones, thus reducing overall market volatility.
Additionally, some market volatility may have “migrated” into off-exchange transactions. According to JP Morgan, the share of off-exchange trading in US equities has surged from 21 per cent to 37 per cent of the total in the past five years. Trading off-exchange is cheaper than in official stock exchanges, so it tends to attract shorter-term investors.
As a consequence of this, volatility in the major indices may underestimate the true level of volatility in the marketplace.
Such a shift could partially explain the conundrum of implied volatility and trading volumes both being at record lows — in theory, low trading volumes should lead to higher volatility.
Furthermore, a prolonged period of very low realised volatility makes it costly for investors to go long volatility and buy protection. This depresses volatility even further.
Indeed, this has turned into a low-volume, low-conviction, low-volatility bull market.
Yet experience shows that sharp drops in volatility are often followed by spikes, with damaging consequences for investors. History suggests that a reversal in market volatility comes via certain routes: a shift in US monetary policy, as seen in February 1994; a significant change in the economic outlook, as occurred during the oil shock of 1990 or the US inflation scare in May 2006; a black-swan type of event in financial markets, such as the collapse of US hedge fund Long Term Capital Management in 1998 and, the fall of Lehman Brothers in 2008 or the 2011 US debt rating downgrade.
Market cycle
At this point in the market cycle, we believe the Fed is the main threat to this period of lower volatility. Market participants are expecting lower interest rates than the Fed’s own forecasts at a time when leading indicators of both growth and inflation in the US are picking up.
Inflation fears in the US in May 2006 were the trigger for a sharp pickup in volatility and a significant bull market correction, which led to a decline of 12 per cent for the MSCI All-Country equity index in just over a month.
In other developed economies, the low level of volatility stems from the fact that many central banks are also maintaining low interest rates, leaving little policy divergence. However, the monetary policy path may have already started shifting: New Zealand and the UK are moving ahead in their tightening cycle, pushing the short end of their yield curves and currencies higher.
As the experience of the BoE (Bank of England) shows, dovish forward guidance is not set in stone; it can be abandoned if the economic outlook changes.
There are other signs that a change in this low volatility environment may be on the cards.
The volatility skew in equity markets — the gap in market prices between put and call options — has jumped to near record highs, favouring puts. This suggests that investors attach a higher probability to a big fall in markets than a big rise.
Furthermore, geopolitical risks remain high in the light of events in Russia, Ukraine and Iraq, and in the past oil price shocks have featured among the triggers of a sudden spike in market volatility.
Prepare for a reversal. The low volatility regime always sows the seeds for higher volatility by encouraging more risk taking.
In the past four episodes of volatility spikes in mature bull markets with economic growth around potential (1994, 2006, 2007 and 2011), equities fell 10 per cent on average in the space of about a month or less, while bonds sometimes failed to provide any protection.
History shows that a period just before a Fed interest rate hike can be volatile. Macro-prudential measures are a new experiment, so they could create uncertainty and volatility.
With bond yields near record lows and inflationary pressures rising, a short position in developed government and investment grade bonds may be attractive. At a minimum, investors should put some hedges on their long risk exposure or trim the risk profile of their portfolio.
A sudden spike in volatility is likely to hit the most crowded trades, including European equities and peripheral euro zone bonds. Credit markets are also very vulnerable, particularly as a decline in secondary market liquidity could exacerbate price declines.
But a spike in volatility would not be a negative development for all asset classes. Investors should not assume that the current bull market will come to an abrupt end just because volatility is going to rise.
Rather, a rise in implied volatility indicates we are merely entering a mature phase of the business cycle, driven by economic growth rather than central bank stimulus.
— The writer is the chief strategist at Pictet Asset Management