This Is ‘The Most Intriguing, Worrying’ Factor For Volatility (Hint: It’s The Flow, Stupid)

The wire headlines were catchy.

That’s Deutsche Bank’s take on yesterday’s Bloomberg interview with Richard Thaler, who of course won the Nobel Prize in economics this week. If you missed it, here’s the clip:

Ok, so Thaler’s contention is that risk assets are “napping through the riskiest moment of our lives.” His words, not mine, although I agree.

As we noted yesterday in our original short post on this, the dynamic that’s created this worrying state of affairs isn’t a mystery. There are readily identifiable reasons for the disconnect between geopolitical uncertainty and market-based measures of vol. Deutsche Bank detailed 5 of those over the weekend. Here they are:

1. Implied volatility is closely linked with realized volatility and the latter has been near historically low levels (Figure 16).
2. High implied volatility tends to be associated with economic downturns. Solid and steady macroeconomic momentum and corporate earnings in recent quarters is thus a key factor keeping vol low.
3. Monetary policy transparency is at historical highs, limiting the degree of surprise from central bank decisions. This is especially true for the Fed. Moreover, expanded central bank balance sheets have flooded markets with liquidity, helping to damp volatility and compress risk premiums.
4. More speculatively from our side, elevated levels of EPU have been driven significantly by issues that point to upside risks to growth, namely tax cuts / reform, de-regulation, and increases in defense and infrastructure spending. Given the inverse link between macroeconomic momentum and vol, we may expect that uncertainty which skews risks towards stronger growth actually may depress vol.
5. Relatively unaddressed in the round table was the influence of any changes in market behavior and market structure on measures of implied volatility. Our equity derivatives team has noted that in recent years any short-term volatility spike has been viewed as an opportunity to sell vol, and assets under management in inverse (short vol) VIX exchange traded products has soared. This has reinforced the low volatility environment (see August below). 

Ok, but here’s the thing: while all of that is true, the root cause is not so much that markets are “asleep” or “napping” as it were, but rather that markets are paralyzed. Does that sound familiar? It should. Let’s go to the source of all things wise, Deutsche Bank’s Kocic:

Dissensus has emerged as a new paradigm — an absolute inability to form consensus across variety of contexts, accompanied with an onset of a breakdown of conventional frames of reference. So, what does one do when no decision can be made? Well, one waits. As a consequence, the market flows are slowing down and vol sellers emerging. This is where the things begin to develop ambiguous overtones.

It’s dissensus. And it’s vol. selling as the offloading of “waiting time.” And it underscores what we said earlier this year about the extent to which the “deer in headlights” analogy for tumultuous markets is often misappropriated.

Cue Deutsche Bank’s Alan Ruskin who is out on Wednesday underscoring the same concept in a new note from which the quote at the top of this piece is excerpted. “There are of course multiple explanations for the current low volatility world, and why investor ‘freeze’ appears to be favoured over ‘flight’,” he writes, before listing those explanations as follows:

1. On the behavioural economics side there is the suggestion that many equity investors have entered at good levels and are capable of withstanding fairly sizable negative shocks; and, investors can’t trade or at least time, hypothetical apocalyptic events like a N.Korea accident;
2. On the real economy side — the global recovery may be slow but it is remarkably steady. In the last five years, the IMF’s world growth estimate has varied between a low of 3.02% in 2012 and a high of 3.17% in 2016! The global growth rate is itself just about frozen. Similarly, inflation is not just a story of trend disinflation, but of inflation inertia, evident in inflation neither rising as much as expected in the recovery; or, less remarked, falling as much in the Great Recession.
3. And then there is policy. Central Banks have contributed to low volatility through at least three avenues: a) at its most extreme the BOJ have literally frozen JGB yields, while other Central Banks have been intent on keeping bond yields low; b) the ‘stock effect’ of QE, means that there is strong legacy influence of past unorthodox easing which stabilises the bond market even as Central Banks shift to tighten; c) the post 2008 asymmetric policy approach, to ease when risk is vulnerable, but not remove emergency accommodation on asset market ebullience, represented the globalisation of ‘the Greenspan put’.

Yes, the “globalisation of ‘the Greenspan put’.” How’s that for a good reason not to sell?

And then Ruskin comes to the main point. There has always been considerable debate about what matters more when it comes to central bank asset purchases: is it the flow or the stock that matters? If it’s the stock, well then there’s not much to worry about in the near term (or maybe ever), because there’s a strong argument to be made that central bank balance sheets will remain bloated for all eternity relative to pre-crisis levels. If, however, it’s the flow that matters, well then now we’ve got an issue, and on that point we’ll leave you with one last quote from Ruskin:

As we look at what could shake the panoply of low vol forces, it is the thaw in Central Bank policy as they retreat from emergency measures that is potentially most intriguing/worrying.

We are likely to be nearing a low point for major market bond and equity vol, and if the catalyst is policy it will likely come from positive volatility QE ‘flow effect’ being more powerful than the vol depressant ‘stock effect’.