1Finance

Where art thou volatility? Not here, nor there, but soon to revive, me thinks. Volatility in risk markets is simply the measurement of variation in prices which is often calculated over certain time periods and against the idea of a normal distribution. The most important markers are historical (statistical) volatility and implied volatility. Historical volatility is a retrospective measurement of actual pricing variations whereas implied volatility is the theoretical price of an asset taking into account actual prices, historical volatility, a time component and the risk free rate within a pricing model such as the Black-Scholes model. Both historical and implied volatility have recently declined to cycle lows in many asset classes. The consensus call is for continued calm waters and a potential further decrease in volatility. The consensus call for tame volatility may be underestimating three potential drivers to higher volatility this year: rising inflation and Federal Reserve policy, a taper tantrum and geopolitical unknowns.

The most popular measure of market volatility in the US is the CBOE Market Volatility Index (the “VIX”) which is also known rather ominously as the “fear gauge.” The VIX measures a weighted average of the implied volatility of a wide range of S&P 500 options with a 30 day maturity. Quite simply, the VIX is the implied volatility of the S&P 500 and is frequently thought of as the market’s broad expectation of volatility over the next 30 day period. The VIX has been on a downward trajectory since 2010.

The VIX has an audience across asset classes as it can give insight into the short term biases and leanings of US equity market participants. To be clear, the VIX is one tool to measure perceived volatility and although a high VIX or an upward trend is most often the result of a declining equity market, the gauge can increase as well when call holders refuse to sell options absent a larger premium. Thus, the VIX can be a measure of upside or downside moves with higher numbers representing the anticipation of sharper moves. Somewhat ironically, there are many instances where higher VIX prices correlate strongly to higher prices in the S&P 500 as the fear dissipates and markets readjust.

The VIX and other measurements of volatility have continued to trend down for many reasons including the fact that the world’s central banks have maintained highly accommodative monetary policies. The European Central Bank has just announced a program of direct asset purchases including the cessation of the “sterilization” of their current markets program. Moreover, secondary central banks like the Bank of Mexico have cut rates in an effort to spur higher inflation. Assuming a direct correlation between liquidity and volatility, all of these programs should act as a governor to higher volatility. Other reasons offered to explain the calmness in markets include exceedingly low trading volumes, range bound markets, recently improving economic data and fewer economic surprises, the transparency of corporate reporting, and the perception that there is no immediate catalyst to drive volatility higher.

Although the trend in volatility is clearly downwards, current complacency should not be mistaken for a permanent drift to lower levels without significant bumps higher and mini-reversals within the trends. Once again, investors are putting their faith into central banks which are doing the one thing that they ostensibly know how to do and have done continuously since 2008 – providing ever increasing amounts of liquidity. To be sure, the ultimate effect of non-traditional monetary policy is unknown and the Federal Reserve and the Bank of England are poised to withdraw some of their stimulus in the medium term. Already, markets are pricing in rate hikes in the US for mid-2015 yet doing so without increased volatility. It is reasonable to suggest that the greatest risk to increased volatility and general market stability may be a mismatch between Federal Reserve policies, the expectations of the bond market and microeconomic data. This triumvirate of fast friends may find itself in an increasingly uncomfortable alliance should US inflation data significantly or unexpectedly increase. Admittedly, higher US inflation in a world currently exporting deflation to US shores is not likely to result in the sustained kind. However, the prospect of Chair Yellen attempting to explain away asymmetric inflation readings as transitory should push up volatility in the bond market.

There is also sensibility in remembering that monetary policy changes frequently take longer to translate to market prices than assumed. It is quite possible that the lingering effects of central bank liquidity will not be felt as a primary cause of higher volatility but rather a second derivative premised upon some otherwise routine market upheaval. When long positions are longer and short positions are shorter, based upon liquidity rather than fundamentals, the correlation between liquidity and volatility cited as calming the markets may cut both ways. Increased liquidity may provide for smooth markets at the outset but higher levels of risk may creep upon casually disciplined risk managers and with it the miasma of higher volatility.

Another reason that volatility could creep higher is the possibility of a “taper tantrum” over the final end of Quantitative Easing. As an analogue one need only to look at the increase in volatility as measured by the VIX after QE2 ended in June of 2011.

The Federal Reserve’s “stock versus flow” argument will be put to the ultimate test assuming tapering continues apace and QE ends toward the end of 2014.

Volatility may also temporarily and dramatically increase due to unexpected geopolitical events. There is a mini civil war in Ukraine right now and it threatens to draw European powers into supporting a proxy contest for Eastern Ukraine between Russia and the West. While Europeans go about deciding where to holiday this summer, the conflict in Ukraine is likely to remain in a sort of pressure cooked stasis. Once the weather turns cold and natural gas for heating is no longer an abstraction the conflict in Ukraine will either resolve quickly or find another gear. Beyond Ukraine, nuclear negotiations with Iran continue to simmer, China and Japan yap at each other and Assad kills off his critics in Syria. Any of these issue may cause a spike in volatility and to expect all of these issues to transpire exactly as a game planned seems rather naïve.

It is true that volatility has decreased. The CBOE Commitments of Traders Report for VIX futures shows a significant net long position for financial players confirming the bias to groupthink towards increasingly lower volatility. This tendency towards anticipating ever decreasing or steadily low volatility flies in the face of the fact that the VIX currently trades at a 45% discount to its longer term historical price average of $20. The odds of a temporary spike in volatility are very good over the remainder of the year and a reversal to slightly higher trend volatility is especially plausible should microeconomic conditions warrant even a slight rethink of monetary policy scenarios. To profit from volatility, is usually to buy it when it is not needed, rather than when the consensus theory is “unexpectedly” being pilloried and volatility is exploding higher.


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