Explaining Low Vol In Dollar Terms (Literally)

"We believe that this risk-on phase (that started in January 2016) is coming to an end."

Via Nedbank, h/t Mehul Daya

Globally, across asset classes, volatility remains compressed. This despite record high levels of political uncertainty and the prospect of the US Federal Reserve raising interest rates (and thereby shrinking its $4.5tn balance sheet later this year).

As the oil price bottomed in early 2016, the dollar bull stalled and a risk-on phase started across all the asset classes including volatility (see Chart 4).

A higher oil price supplies more dollars into the global financial system. This funds the carry trade.

We have made it clear over the last few weeks that we believe that this risk-on phase (that started in January 2016) is coming to an end.

We do not expect a sustainable break below the major support line (see the red line on the Global Asset Class Volatility index chart on the left).


We use Principal Component Analysis (PCA) to determine if there is a common factor (principal component: PC1, PC2, PC3 and PC4) that could explain the co-movement of volatility around the world (despite the idiosyncratic risks associated with these assets).

Our findings suggest that volatility across asset classes and regions can be explained by one ‘common factor’ 66% of the time (PC1).

One of the drawbacks of PCA is that it does not provide clarity around what exactly drives the PCs.

However, we have what we think is a reasonable theory; we believe it is related to the USD risk-free rate and the USD.


There are a couple of factors that explain the low volatility phenomenon, namely: Heavy option selling (earn carry) and dealer hedging. However, we also believe that on a broad macro level, the low levels of global volatility can be explained by the low risk-free rate (ie the term premium).

Almost 60% of global asset class volatility can be explained by the US (USD) term premium (which is arguably the indicator of the world’s risk-free rate). The term premium has recently been compressed by central bank actions, the savings glut and regulations.


We believe that the USD is the world’s risk barometer and that volatility measures such as the VIX have moved from being a driver to a consequence of risk appetite.

For many years we have had the view that the USD is the world’s gauge of risk, given that we operate in a dollar indebted financial system.

The BIS shares this view in a recent paper: “The Bank/Capital Markets nexus goes global. November 2016”. It states: “Any simple answer will be misleading, but there is a surprising candidate for the barometer of the appetite for leverage. The answer is ‘the dollar’. The dollar has supplanted the VIX index as the variable most associated with the appetite for leverage. When the dollar is strong, risk appetite is weak, and market anomalies such as the breakdown of covered interest parity (CIP) become more pronounced”




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