LONDON (Reuters) – Perhaps the most remarkable aspect of what has been a bumpy ride for world financial markets this year is how stubbornly low volatility is. It’s as if investors have given up on hedging, which is exactly what appears to be happening.
Benchmark measures of implied volatility across major stocks, bonds and currency markets are historically low, despite the ECB preparing to join the Fed in tightening policy, Italy’s bond market in turmoil and surging global trade war fears.
If that wasn’t enough, the G7 pantomime at the weekend shows that the rules-based international order that has provided the political and economic framework for financial markets over the last 40 years is facing an existential crisis.
But almost all the recent bursts of volatility, in Turkey, Argentina as well as Italy, have remained localised and the spillover to broader markets has been negligible. Even the S&P 500’s “volmageddon” episode in February was short-lived.
This is partly because, at the macro level, the world economy continues to hum along quite nicely. Global growth is north of 3 percent and there’s little sign of it slowing to any significant degree.
The latest Commodity Futures Trading Commission data show that hedge funds and speculators maintained a short position in VIX futures contracts, essentially betting on lower volatility in the S&P 500 over the coming month.
The net short position was trimmed a bit to 36,189 contracts from 44,380 the week before, but these are figures for the week to Tuesday, June 5. The VIX has since fallen further, trading with an 11 percent handle for the first time since late January.
The VIX index is now at 12.5, below its median over the last five years of 14.6. Only four months ago it had its biggest rise in history on fears that accelerating U.S. wage growth would force the Fed to jack up interest rates far more aggressively than investors had bargained for.
(For a graphic showing VIX index, click here: reut.rs/2MgloOX)
The fact it’s come back down so far so quickly suggests investors still have very little appetite to protect their positions and portfolios via the options market.
“Have people given up hedging? Hedging seems to be a bad idea because you just end up losing money even on the outcomes you’re hedging against, such as Brexit or Donald Trump getting elected,” says Citi’s Matt King. “Up until now, markets have always bounced straight back.”
It’s a similar picture, although not quite as stark, in currencies and bonds.
Deutsche Bank’s currency volatility index is currently at 7.6, below the average over the last five years of 9.3, and the one-month Mermove index of implied volatility in U.S. Treasuries 59.6, compared with the five-year average of 68.3.
(For a graphic showing FX volatility, click here: reut.rs/2MihLrz)
(For a graphic showing U.S. Treasuries volatility, click here: reut.rs/2MjLCAa)
Central banks’ quantitative easing has shaped this mentality as investors have come to assume that central banks will step in at the first sign of market turbulence or economic fragility, the so-called ‘central bank put’.
The S&P 500 reached an all-time high of 2,872 points on Jan. 26 then lost more than 10 pct in the following two weeks as the “volmageddon” shock ripped through world markets. But recovery has been steady, and it closed within 100 points of that peak on Friday. The booming tech sector boom lifted the Nasdaq to fresh highs on Friday too.
Trouble is, the herd mentality it has fostered means the entire market has the same volatility trade on. Selling and being short volatility has been such a money-spinner, few are willing to go the other way. At least not yet.
There’s no shortage of risks to hedge against, but that may be part of the problem. Hedging against every potential risk is impossible, and prohibitively expensive. So if you think the central banks have your back, why bother?
That’s been the story of the first half of the year, even as the Fed has continued raising rates and the 10-year Treasury yield finally broke above 3 pct for the first time since 2011. Will it continue to be so in the second half of the year?
Citi’s King is sceptical, as are analysts at Morgan Stanley. They reckon implied volatility is too low and the return (or carry) from selling vol offers an insufficient cushion for when volatility does turn higher. They advise going long volatility.
A major variable will be the length of the economic cycle. Many analysts think the U.S. economy, with the labour market its tightest in 50 years, by some measures, will soon roll over. But others, like those at Blackrock, believe the growth cycle can continue for years to come.
“Bottom line, selling vol on equity, credit and rates looks quite challenging despite positive carry, unless one is very optimistic on the longevity of the cycle,” Morgan Stanley wrote in a report last month.