Everyone knows the story when it comes to the disconnect between implied equity and bond market vol. and policy/geopolitical uncertainty.
Simply put: vol. isn’t responding. Here, look:
Apparently, no one cares about policy blunders and/or geopolitical uncertainty. Actually, that’s not entirely true. As noted earlier on Monday, it’s probably not so much that no one cares, but rather that everyone is paralyzed and the dissensus is creating a deer-in-headlights dynamic. That, and central banks acting as vol. sellers themselves have conspired to create an environment the defining feature of which is a disparity between markets and geopolitical reality.
But it’s not just equities and bonds. As Bloomberg’s Dani Burger noted earlier today, “currencies have followed suit [with] the JPMorgan FX volatility index plunging after grinding higher through the summer ahead of significant events like the upcoming Japanese election.” So although there were times when it looked like FX vol. was saying something different than rates and equities, the general trend is the same.
In fact, as BofAML writes in a new note, FX volatility is “trapped at historically low levels.” “Low volatility is one of the main conundrums facing markets today [as] the rise of nationalism, populism and protectionism around the world suggests that volatility has plenty of excuses to surge,” the bank writes adding that “the fact that it remains at extremely low levels across markets implies that the market is not pricing in much risk.”
Having dispensed with the obligatory recap of the prevailing dynamic, BofAML presents some pretty interesting data. Check this out:
We measure volatility clustering using half-life: how fast volatilities decay in response to a shock. We find the current volatility is 6 times more persistent than normal times. Chart 1 shows the half-life of all G-10 pairs using the last 15 years of return data and the most recent one year data. Notice that volatility persistence has increased to historically high levels in the past year. The average half-life for most currency pairs is around 600 days compared with less than 100 days using the whole history. The six-fold increase in persistence is an indication that volatility is extremely sticky at the moment.
In other words, it takes six times as much effort for volatility to jump to higher levels now than it would during more usual times.
Given that, it won’t surprise you to learn that “volatility is 3 times more responsive to shocks historically than its current level.” Here’s the chart on that:
BofAML’s conclusion: vol. is unlikely to sustain a spike barring some kind of truly game-changing event.
But there’s a caveat: FX vol. is now far more sensitive to negative shocks than it has been in the past – roughly twice as sensitive, in fact:
Here’s the accompanying color:
It is clear that the magnitude of the asymmetry has increased for most currency pairs versus their pre-crisis levels. This indicates that volatility is more responsive to one-sided shocks now: a market sell-off could trigger a large volatility spike, the magnitude of which is multi-fold higher than the pre-crisis level.
Gee, I wonder what might account for that? Algos maybe? Liquidity vacuums? One is reminded of something DB’s Oliver Harvey wrote way back in 2015. Go look that one up.
