Week ahead: the volatility puzzle

REUTERS

A bull and a bear styrofoam figurine.

As markets' summer doldrums leave financial volatility and trading volumes at their lowest in years, investors are puzzling over what appears to be complacency about the potential for renewed market tensions during an event-packed September.

And on the face of it at least, stock market pricing looks out of whack. Heading into a period that is likely to see fresh debate over how to solve the euro zone crisis and a heated US election race, with the world economy still shaky and markets second-guessing central banks on extraordinary policy moves, you'd expect volatility to be pumped up.

On the contrary. Wall St's measure of implied one-month volatility in the S&P 500 - the so-called 'Fear Index' or VIX - typically acts like a seismograph for world markets but fell this week to its lowest level since before the credit crisis exploded five years ago this month.

On one level, that shouldn't be a big shock.

Year-to-date gains for US equities are the second best since 1998, and the past fortnight has seen some of the narrowest trading ranges in decades.

Volumes are way below historical averages and US economic data and earnings are mixed at worst.

European stocks, meanwhile, are set for an 11th week of gains, their longest winning streak since 2005.

Add to that implied “policy puts” from the US Federal Reserve and European Central Bank that promise intervention through more quantitative easing if the situation deteriorates again and you get a sense of what is beneath the relative calm.

The tentative re-emergence from safe-haven bunkers such as US Treasury or German government bonds

over the past two weeks underlines the shift in behaviour.

Given that the VIX and other volatility signals are used in investment models around the world as proxies for risk, their steady decline acts as green light for risk assets everywhere.

But if markets are supposed to discount future risks, many say potential ructions in September - evident from even a glimpse at next month's event diary - should imply more caution than we are now seeing.

And if this is just a market anomaly, then investors should be exploiting it by buying what looks like relatively cheap insurance for the bumpy road ahead.

“In this period of relative summer calm, risk assets continue to be well-supported as the market appears to enjoy the “thrill of the chase” in the expectation of additional central bank easing,” said Ian Stealey, portfolio manager in the International Fixed Income Group at JP Morgan Asset Management.

Stealey reckons room for policy disappointment is high, however, and that the market is not adequately priced for surprises.

“As we move into September and possible headline risk on both sides of the Atlantic, it is worth remembering that since 2010 the VIX has only dipped below 15 twice. In both instances the subsequent two-month performance for the S&P 500 was negative.”

'KURTOSIS' AND POLICY DOMINANCE

However, there is another view of what's happening at the market coalface and options pricing that suggests the current environment could persist for much longer.

Gerry Fowler, BNP Paribas' Global Head of Equity and Derivative Strategy, says world equity volatility pricing is not all it seems.

Firstly, he stresses that the VIX measures implied volatility for just one month. And while this is now at five-year lows of about 14 percent despite September's noisy calendar, longer-term gauges out to one year remain sticky above 20 percent, and the gap between short and long-term volatility is as wide as at any point in the last three years.

This suggests the short-term lull is temporary, related to the holiday season and that anxiety about the longer term is really as high as ever. But that's not the full picture either.

Fowler says his analysis of four years of the crisis shows that while days of outsize price swings in equities are still common, volatility on routine “non-event” days has more than halved, to 0.4 percent from 1 percent in 2008.

Given that non-event days still vastly outnumber the swing days, that decline is swamping gauges of median volatility such as the VIX.

There are many theories on what's driving what statistical wonks call “kurtosis”, or infrequent but extreme moves in a data series. But the huge potential impact of central bank and government policy intervention is the biggest factor.

Fowler posits that, because fundamental market analysis based on relative value models, earnings or economic trends is almost pointless when faced with the overwhelming effects of QE or euro zone developments, investors simply avoid trading on days except those when policy changes are driving market.

Trading turnover thus evaporates on “non-event” days, further deterring investors from transacting for fear of moving the market in such thin volumes. The net effect is to cut median volatility despite the same number of days with big gyrations.

So if one of the aims of policy intervention is to dampen market volatility, it may well be succeeding - even if not for

all the intended reasons and with uncertain consequences.

“Policy intervention has become so variable and so frequent it is stopping people becoming involved in the market on a daily basis, and they then simply have to act very, very quickly when there's an intervention catalyst,” said Fowler.

“As a result, it may not be as attractive to buy volatility as you might think, even if one-month is probably about as low as it's going to go here,” he said.

His “best guess” on reactions to the many Fed, ECB, euro policy and US election events over the coming weeks is that they are unlikely to produce the sort of daily swing needed to justify buying indexes like the VIX current levels.

Next week certainly looks too quiet to change things, even if Fed policy minutes will be of interest. Flash August business polls from around the world are set to be watched closely, as will revised figures for second quarter UK gross domestic product and an auction of German two-year bonds that are still currently offering a negative yield. - Reuters