What was it we said on Thursday evening in “Volatility Has Collapsed Across Assets. One Bank Asks “Now What”?
Oh, that’s right, we said this:
Volatility has become the market’s perpetual topic du jour (does it make sense to use “perpetual” and “du jour” in the same sentence? Not sure on that).
Suppressed vol has become ubiquitous. And the amusing thing about ubiquity is that it has a way of making everyone think they’re entitled to have an opinion on whatever it is that’s ubiquitous. That’s certainly the case with volatility — these days, everyone who’s bought themselves some VXX or XIV lately thinks they’re Rocky Fishman.
That’s the (black) magic of VIX ETPs. Hordes of retail investors have been transformed virtually overnight into futures traders much the same way as the rampant proliferation of margin debt in early 2015 helped turn every bored housewife in China into a leveraged Shenzhen day trader.
This dynamic has created a veritable cacophony of explanations as to why equity vol is so low.
If you cut through the noise, it’s probably some combination of plunging stock and sector correlations; gamma; central bank liquidity; and a kind of “success breeds success” dynamic in short vol strats.
Of course low vol isn’t unique to equities. This is a cross-asset phenomenon and indeed, it’s created a veritable bonanza in credit as BofAML’s Barnaby Martin recently outlined.
That was our assessment of the ongoing and often rancorous debate around persistently suppressed vol.
If you care to peruse the Rocky Fishman article linked above, you can find out more than you probably ever wanted to know about the technical factors that are in the driver’s seat.
In that post, you’ll also find a reference to one of the more popular pieces we’ve published this year. Namely this one: “Investigating The Market’s Nightmare Scenario.”
There, we explored the self-referential, circular dynamic that VIX ETPs, vol targeting strats, CTAs, and risk parity have created and perpetuated. The interplay between those strats has created the recipe for a vicious, self-feeding unwind in the event the day of reckoning finally comes for volatility.
Well, underscoring our contention that his debate has become ubiquitous is the following Bloomberg Op-Ed penned by Dean Curnutt the CEO of Macro Risk Advisors.
Do note the references to virtually everything we’ve discussed in these pages since this site’s inception.
A terrorist attack at a concert in the U.K. killed more than 20 people and injured many more. North Korea continues its provocative ballistic missile tests. A huge cyber-attack affected 200,000 computers in more than 100 countries. The U.S. president fired the FBI director, leading to questions about whether he obstructed justice and even raising the specter of impeachment.
In normal times, one would expect these turbulent events to be reflected in volatility in asset prices. But these times — when financial market outcomes are being suppressed by overriding forces of monetary policy, money flows and investor expectations — are not normal. There is a particular risk that investors construe the substantially low readings of volatility as signs that market conditions are benign, when, in fact, they are not.
Of all the dangers in the world of finance, the enduring low level of market volatility is the most significant. How quiet is quiet? Recently, the six-month realized volatility for the S&P 500 dipped to 6.7 percent, lower than even the period leading up to the financial crisis of 2008-09. During the mid-’90s, volatility was as low as it is now, but the size, complexity and interlinkages of financial market exposures were far less significant. Now, fluctuations are severely muted, and thus send a false signal of safety to both investors and policy makers who misread the calm as an “all clear” sign, dismissing the events above as insufficiently relevant. The result is an inability to appreciate how quickly market conditions can change, especially as trading strategies that capitalize on quiet markets become vulnerable to unwind, serving to amplify a risk-off event.
With great thanks to the central banks, market participants have increasingly learned to live in the moment. When short-term rates are held below the level of inflation for eight consecutive years and the Federal Reserve consistently articulates the most market-friendly and gradual path toward normalization, investors are forced to embrace alternatives to holding cash. There can be little doubt that former Fed Chairman Ben Bernanke’s portfolio balance channel has been effective in pushing investors into risk assets. By making the forward-looking valuation profile of sovereign debt vastly unappealing, the central banks make risk assets cheap by dangerous proxy. What results is a world in which the blended valuation of stocks, bonds and real estate has rarely been as stretched as it is now.
Asset prices are full, but negligible volatility encourages exposure to them without any discomfort. There are losses here and there, but in general, the daily experience of mild moves is the relevant, affirming scorecard. Further, low volatility serves not as just an anxiety-reducing palliative, but also is a mathematical driver of trade sizing codified into hundreds of billions of risk managed investment strategies. Volatility control products, for example, gear up or down exposure to the equity market based on the level of realized volatility versus a preset target. Because of the diminutive daily moves in equity indices, products such as volatility control move toward their maximum long exposure. The sell signal for volatility control and other strategies like it is unambiguous: a rise in realized volatility. Stewards of capital should be actively considering the potential knock-on effects that result from contractual deleveraging triggered by the inevitable volatility spike.
There is an important debate in markets now about the causes of low realized volatility. A decline in the correlation among stocks, a global economy on more stable footing and a decline in perceptions of systemic risk (a euro-zone unraveling, for example) are among the factors. We should appreciate the importance of money flows as well. According to ETF.com, the exchange-traded fund industry is on pace for $500 billion in new asset growth in 2017. These vehicles can provide cheap, liquid access to market risk exposures. They simply put the money received to work in passive fashion, without evaluating the risk/return trade-off. The flows themselves are a factor in the positive returns and the low volatility that, in turn, attract additional flows.
What results is a dangerous circularity. Recall the period of wonderful outcomes preceding the financial crisis. The demand for housing spurred price appreciation, which enabled mortgage credit to be supplied at increasingly generous terms. The most suspect credit cannot default if the value of the collateral keeps appreciating and, as a result, the supply of credit keeps expanding. The fear of missing out is also supremely powerful. The conservative individual becomes less so when he or she sees a neighbor flipping houses with success. Similarly, the conservative lender is forced to compete with more aggressive suppliers of credit. For lenders, not being accommodative enough during the go-go years can amount to an existential business question.
Today’s risks differ meaningfully from those of a decade ago. However, the excess amount of capital chasing opportunity at increasingly aggressive terms is similar. The competition to put money to work, then, like now, results in low volatility. Investors are in danger of misinterpreting this tranquility as conveying safety when crowded positioning is resulting in more, not less, risk. While spending money on hedging is especially difficult in a seemingly benign environment, investors should be actively vigilant to market risks, devoting time to an action plan that helps protect portfolio wealth against the inevitable return of volatility.