MARKET VOLATILITY HAS BEEN LOW, ENCOURAGING RISK-TAKING / THE ECONOMIST

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Market volatility has been low, encouraging risk-taking

…and raising fears about what may happen when it rises



MAY YOU live in boring times. Financial markets have become dull, if profitable. The S&P 500 index, America’s leading equity benchmark, has notched up its longest-ever streak without a 5% reversal. Bond yields may have inched up in recent months, but are still at the bottom of historical ranges. Institutions famed for their trading prowess, such as Goldman Sachs, have seen profits dented by the quiescence of the markets.

This lack of market volatility owes much to the steadiness of monetary policy since the depths of the financial crisis. Central banks have kept short-term rates low and have intervened to push down bond yields through their programmes of quantitative easing (QE). The classic method of pricing financial assets is to say they are worth the discounted value of future cashflows; since central banks have kept the discount rate steady, prices have been steady too.

The late Hyman Minsky, an economist, thought that long booms sowed the seeds of their own destruction. He argued that, when the economy was doing well, investors tended to take more risk (such as taking on more debt). These speculative positions are vulnerable to a shock, such as a sudden rise in interest rates, which can turn into a fully fledged crisis.

In these days of sophisticated markets, speculators are not restricted to their own capital or even to borrowed money to buy assets to bet on the good times continuing. They can use derivative instruments to bet on prices. Indeed, there is actually a market in volatility.

The steadiness of the S&P 500 shows that actual, or realised, volatility has been low. But investors can also hedge against a sharp move in the stockmarket (in either direction) by taking out an option, giving them the right to buy or sell equities at a given price within a set period. The price, or premium, they pay for this option reflects a lot of factors. But one of the most important is how choppy investors expect the market to be in future. This measure is the “implied” volatility of the market and is the basis for the well-known Vix, or volatility index.

Speculators who believe markets will stay calm can sell (or “write”) options on volatility, earning premium income. The more sellers there are, the more the price, or premium, will fall (and the lower the Vix will be). The danger, then, is that a sudden pickup in volatility could result in speculators suffering losses. A linked issue is that investment banks use a measure called “value at risk” to help determine the size of their trading positions; reduced volatility will encourage them to take more risk. Since volatility tends to rise when asset prices are falling, this could be accompanied by much wider financial distress.

Two recent papers* from the New York Federal Reserve have examined this issue. The authors point out that low volatility tends to be persistent; historical data show long periods of calm interspersed with short spikes in the form of crises (see chart). So low volatility today is not necessarily a warning sign. The authors write: “On average, extremely low volatility today predicts low volatility in the future, not higher.”

However, the Vix measures the implied volatility over just a one-month horizon. It is possible to calculate implied volatility over a two-year period, creating a slope akin to the yield curve, which measures interest rates for different lending durations. Back in 2006-07 this volatility curve was very flat, suggesting that investors thought that conditions would continue to be rosy. That may explain why so many were caught out by the problems in the subprime mortgage market.

This time, the Fed says the volatility curve is steeply upward-sloping (since 1996 the slope has been steeper only 15% of the time). This suggests that investors are not complacent at all, and think that volatility may soon return. Investors seem to think the Vix may be as high as 20% (compared with around 11% today) within the next one or two years.

The obvious catalyst for such a change is monetary policy. The Fed is pushing up interest rates and slowly unwinding QE; the European Central Bank is scaling back its bond-buying. So far, this process has occurred without any great alarms. But there may yet be a “tipping point”, when higher rates cause problems for investors and borrowers. In any cycle there is always some institution that has taken a lot more risk than the rest. If a storm comes this year, the world will discover who has gone out without a coat or umbrela.


* “The low volatility puzzle: are investors complacent?” and “Is this time different?” by David Lucca, Daniel Roberts and Peter Van Tassel