How many times are we going to revisit the low vol. story?
That’s a dumb ass question. That’s like asking when people are going to stop talking about Bitcoin.
People will stop talking about it when things return to some semblance of normalcy, although to be sure, it’s no longer clear what “normal” even means for vol. Because between dramatic shifts in market structure (VIX ETPs, vol. as a favorite momentum trade, vol. targeting strats, etc.) and central banks effectively acting as vol. sellers themselves, no one knows whether and to what extent historical precedent even matters anymore.
One thing is certain. The factors listed above along with the impact of indiscriminate flows (e.g. passive serving as its own form of QE, SWFs, etc.) have created a veritable perpetual motion machine – a self-fulfilling prophecy – a series of feedback loops that continually suppress vol. and compress risk premia across the board.
Given the amount of time everyone has spent on this, it’s not entirely clear that it’s a “conundrum” anymore. That said, anytime a regime shift of this magnitude has taken place, it’s almost by definition true that no one understands it fully and so in that sense, there’s enough built-in ambiguity to couch it in terms of an enigma, which is exactly what Deutsche Bank’s Masao Muraki is doing in a new note.
Here’s his take on rates vol.:
US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding. In our view, this model suggests that the fall in interest rate volatility was led by (1) a decline in general investors’ ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.
And on equities vol.:
In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.
The problem – as noted here at the outset – is that by virtue of being structural and endemic, the factors suppressing vol. are creating the conditions whereby if the regime were to suddenly shift thanks to, say, a sudden surge in inflation that causes central banks to stop consulting the market with radical transparency (i.e. forward guidance), the stage is set for a “sudden spike.”
“We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility,” Muraki notes before warning that “there is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.”
You have been warned (again).