May 29, 2014 5:16 pm
Tranquil markets are enjoying too much of a good thing
After years of monetary experiments, central banks will do ‘whatever it takes’
Something peculiar is happening in western capital markets. This month almost every measure of volatility has tumbled to unusually low levels. If you look at the degree of actual (or “realised”) price swings – and projected (or “implied”) future movements – investors are behaving as if the world is utterly boring.
This is bizarre. Financial history suggests that at this point in an economic cycle, volatility normally jumps; when interest rate and growth expectations rise, asset prices typically swing (not least because traders start betting on the next cyclical downturn). And aside from economics, there are plenty of geopolitical issues right now that should make investors jumpy. European elections have just propelled populist leaders into power, and events in Ukraine and the Middle East are tense.
But investors are acting as if they were living in a calm and predictable universe. Take a look, for example, at Wall Street’s so-called “fear index”, the Vix, which measures the implied volatility of S&P 500 equities. During the financial crisis this surged above 80, and later sank to half that; it is now just above 11, a low level not sustained since 2007.
“There is no demand for protection [against turbulence],” observes Mandy Xu, an equity derivatives strategist at Credit Suisse. “[Investors in] the options markets are not pricing in any big macro risks. This is very unusual.”
Why? If you want to be optimistic, one possible explanation is that the economic outlook has turned benign. For while western economic growth rates have been disappointingly slow since 2008, the good news is that recovery is now afoot, at a surprisingly steady pace. The disaster scenarios that used to spook investors – such as an imminent break-up of the eurozone or technical bond default in Washington – have not materialised; or not yet. More important still, after several years of wild monetary experiments, investors are more willing to accept that western central bankers will do “whatever it takes” to support the markets; they thus expect rates to remain stable and low for a long time – even if some central banks, such as the Federal Reserve, reduce their level of stimulus.
And there could be a more subtle issue at work too: investors are so unsure what to make of this level of government interference that they are unwilling to take any big bets. Far from being a sign of sunny confidence in the future, ultra-low volatility may show that investors have lost faith that markets work.
In reality, nobody knows which of these explanations holds true; I suspect that government meddling and low interest rates are the key factors here, but academic research on this issue is thin. However, one thing that is clear is that the longer this pattern remains in place, the more wary investors and policy makers should be.
For while ultra-low volatility might sound like good news in some respects (say, if you are a company trying to plan for the future), there is a stumbling block: as the economist Hyman Minksy observed, when conditions are calm, investors become complacent, assume too much leverage and create asset-price bubbles that eventually burst. Market tranquillity tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash.
Copyright The Financial Times Limited 2014.
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