The Demise of Volatility

This is a subject that has been talked about at length in various formats, mainly in the context of how Central Banks have implicitly underwritten markets since the GFC and thus dampened volatility. But there’s another aspect that is rarely touched on that has become more obvious over the last 18 months.   

Traditionally, when investors have talked about sharemarket volatility, they referred to the magnitude of fluctuations for individual stocks or the broader market. Volatility was a unit of measurement, like speed or weight. That is, you observed the number as a measure of what markets were doing or of investors’ expectations of likely movements. 

This gradually changed with the evolution of market instruments such as the CBOE Volatility Index (“VIX”), that didn’t just measure volatility, but became widely tradable entities in their own right.  Market participants could now take a view on the future direction of volatility and bet on it directly. 

Since the VIX became tradable, it has grown immensely popular for both hedgers and speculators.

As market conditions have become increasingly benign over the current cycle, investors are increasingly only taking one side of the volatility trade – the short side. To use an analogy, more and more market participants are taking the bet that it’s “not going to rain tomorrow”, and are selling insurance on that basis. This has been a particularly attractive profit centre in a world of low interest rates for those that are assuming it will “stay sunny”. 

Net Positions on VIX

All these bets on “no rain tomorrow” are amidst the lowest interest rate environment in living memory, expensive equities, vast outstanding global debt and heightened geo-political risk.

The chart below shows the VIX against a proxy for Economic Policy Uncertainty (“EPU”). Up until the European Crisis in 2011, these two indices effectively mirrored each other. However, the last few years highlight that markets have largely ignored EPU and have continued to push volatility lower and lower.  

VIX vs. Economic Policy Uncertainty

Despite the promises of Yellen, Draghi and Kuroda to keep it sunny, we know rain will inevitably come. It’s impossible to eliminate external shocks to the global system - and the number of investors ‘short volatility’ could well turn the next rainfall into a flash flood. 

 

By James Caughey (Senior Research Analyst) and Dan Jenkins (Business Analyst) at NZAM