One burning question this year has been why volatility has remained so stubbornly low.
At a base level, this is kind of a silly question if you’re talking about the VIX. That is, January was the fifth calmest month on record as measured by realized vol and if low realized vol begets low implied vol, well then…
But one of the important things to note is the extent to which collapsing stock and sector correlations have contributed. And do you know what’s driven S&P correlation so low? Here’s a hint: the fact that there are clear winners and losers from the Trump agenda. Recall this from Goldman:
US stock correlations have plummeted, driven by falling correlation between sectors. S&P 500 average 3-month realized stock correlation hit 0.09 earlier this month, the lowest level since the mid-1990s. However, correlations within sectors have declined less than the correlations between sectors, reflecting the relatively “macro” potential consequences of the new administration’s proposed policies and recent economic acceleration as well as the investor use of ETFs to capture those dynamics.
So with that in mind, consider the following out Thursday from SocGen, who explains that while the Fed was behind the suppression of volatility in 2016, low vol in 2017 is a consequence of reflation and the reflation trade.
Key differentiation between the old and new drivers of low vol
In 2015, the bond market was pricing in c.3.5 rate hikes by the Fed. Concerns over a devaluation of the renminbi by China as well as fears of recession in the US led to sharp repricing of the pace of hikes. Even though the Fed had tapered its QE programme, we argue that this accommodation by the Fed went a long way in bringing down equity volatility as financial markets took their time to catch their breath. Post-Brexit dovishness from the Fed again provided support for the risk assets, leading to a lower vol environment. However, the market is now pricing in the strongest pace of hikes since late 2015, and the Fed has moved to the other side of the volatility equation. It is now more likely that the Fed will contribute to higher volatility if the market deems financial conditions to have become too tight.
Instead, a reflationary environment and expectations of a further boost to growth resulting from policy changes in Washington are now the primary drivers of the extremely low volatility. While reflation has traditionally been good for equities, it has additionally caused unprecedented internal churn amongst rate-sensitive sectors within broader equity markets, further suppressing the magnitude of volatility. We find this change in the drivers of volatility dynamics to be quite significant. We expect further reflation, as expected by our analysts, to continue to help maintain low levels of equity volatility – although we also believe that the lows in vol may be behind us.
Extensive sector rotation is a consequence and a culprit
From a technical perspective, index volatility is a function of not only average single-stock volatility, but also of how stocks within the S&P 500 are moving with respect to one another – a measure of correlation. When the correlation is low, most stocks move in different directions. With all these individual stock moves, there is no clear direction to the overall index, and this, in turn, dampens down volatility. The short term (three month) average pairwise correlation among the S&P 500 sectors touched its lowest level since 2002, while the 3m realised volatility reached its lowest level in the past 27 years and is in the 3rd percentile since 1928 (see charts below). The short-term implied volatility (as measured by the VIX) depends primarily on realised volatility. If realised volatility is low, and expected to remain low, especially because of the dampening effect from the low realised correlation among stocks, the short-term implied volatility is likely to remain subdued, as the cost of carrying long vol positions is too high, making sure implied vol converges towards realised.