Who ate the market volatility?

Thu Dec 13, 2012 5:38pm EST

Related Topics

(Reuters) - For an uncertain world - one with fiscal cliffs, eurozone recession and regime change at the Federal Reserve - it sure is quiet out there.

Volatility in financial markets is now trading more like we are in the pre-crisis world of 2006, rather than one in which most of the crucial questions are left unanswered.

Sometimes called the fear index, the VIX which gauges investor perceptions of how jumpy the S&P500 stock index will be in the coming month, is now trading at around 16, more than 60 percent below its 2011 peak and not too far above its median level for the past century. In fact, if we get through December without a major market upset, 2012 will be the first year in seven without a significant spike in the VIX.

In theory this should be very good for riskier assets, as volatility has a nasty habit of flushing out investors. But in practice the outlook for 2013 may hinge on whether the forces suppressing volatility can keep the market placid.

To figure out the likelihood of that, you have to answer a question: is the low volatility a return to normal, perhaps supported by changes in the structure of markets, or are markets being tranquilized by "quantitative easing" by central banks and low interest rates?

If you believe, as I do, that volatility is low mostly because central banks are dousing markets with liquidity, then your call on next year is really a reverse call on the Fed's success. The conundrum is that we have people living as if there will be tremendous volatility, and the dearth of capital investment is the best example of this, but financial markets pricing the world as if there will be very little volatility.

Analysts at investment bank JP Morgan have done an interesting study summarizing exactly how out of whack volatility markets are. They looked at 484 macro-economic indicators which have a meaningful historical correlation to the VIX and then ran a regression study comparing how they have changed and whether that is reflected in the current VIX.

"Results show that the current low VIX level is in stark contrast to virtually every macroeconomic indicator across the globe," Marko Kolanovic of JP Morgan wrote in a note to clients. Specifically, if the VIX were trading in line with U.S. indicators it would be more than 40 percent higher. If it were being driven by European indicators it would need to be about 60 percent higher.

HEDGE FUNDS ALONG FOR RIDE

That's not to say a spike is imminent. There are powerful forces driving volatility lower, with many investors seeking to piggyback off a generous Federal Reserve which only yesterday pledged action that will expand its book of bonds by more than a trillion dollars in 2012. Remember, that's a trillion newly created dollars seeking a home.

The Fed, of course, is doing this precisely to encourage investors to come along for the ride. Federal Reserve Chairman Ben Bernanke has been explicit about his hope that quantitative easing drives money into riskier areas than mortgage and government bonds. So far, it is working.

Hedge funds, according to Societe Generale, are massively short the VIX, with the amounts being bet so huge they are more than five standard deviations away from the average since 2005. That makes for a once in a century or so event. Of course, most of what has happened in markets and the economy since 2005 has been a once in a century event.

Cullen Roche, of advisory firm Orcam Financial, believes it is more likely the VIX will revert to mean, arguing that a 20-year view shows room for further moves downward with fear among investors still high.

"Wake me up when this index does something that sends us shooting (in either direction) away from the mean. As opposed to what looks like a big coin flip here...," he wrote in a blog post. (See: here)

And, to be sure, there have been big structural changes in markets driving volatility lower. Equity trading is near historic lows, with something over half of the trades that are being made executed by high frequency traders or exchange-traded funds, both of which tend to make stocks more highly correlated with one another and reduce index volatility.

None of this, not the hedge funds or the HFTs or ETFs, are powerful enough to suppress volatility without help from the Federal Reserve. The Fed, as it explained yesterday, is going to keep its foot on the gas until unemployment hits a threshold of 6.5 percent or inflation shows signs of moving too high.

If the economy heals rapidly, or if inflation shoots higher, the result could be a burst of volatility, as all the power that has been long suppressed breaks out. That means great news for jobs in 2013 - a real but small possibility - could be lousy news for financial markets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(James Saft)

FILED UNDER: