Morgan Stanley says that it’s understandable that volatility us up for most asset classes, but sees room for US equity volatility to fall again

Volatility is up across the board, in some cases from historic lows to recent highs, but the general pensiveness may be overdone for some asset classes. Equity and credit volatility in particular could come back down, according to a recent Morgan Stanley report.

“Falling inflation, fears over growth and Greece political risks have led to an eventful start to 2015. Equity, credit and FX volatility has risen materially from mid-2014 lows, and across many of these markets now sits above long-term averages,” writes Morgan Stanley analyst Phanikiran Naraparaju.

Asset class vols

US equity volatility on the rise

If you just look at the VIX then volatility isn’t high so much as it’s returned to normal after scraping bottom for most of the last few years, but there are other measures that show how conservative investors are feeling.

US vol at average

US equity volatility skew, how much extra you have to pay for downside hedges, is at a five-year high (it’s still pretty subdued in the EU). Unlike volatility, which strictly speaking just tells you that investors expect something to happen, high volatility skew clearly shows that investors are preparing for a contraction.

US equity vol skew

Similarly, options usually reflect higher volatility the further you go out for the simple reason that uncertainty is greater. But the difference between volatility implied by three month options and one year options is flat right now (eg the equity term structure is near zero), showing that investors are worried about a drop in the near future.

US equity term structure

As you would probably guess, volatility in the energy sector in particular spiked recently as falling oil prices have put the entire industry under pressure. Volatility has is falling again as investors get used to the idea that oil prices might be low for the foreseeable future, but another surprise will send it soaring again.

Energy stock volatility

Tactical correction for the dollar

“FX remains a better place to buy hedges and be long vol in comparison to equities. FX markets remain at the centre of the global fight against lowflation, and a key transmission channel for global rebalancing,” writes Naraparaju.

But he warns that there is a good chance of a tactical USD sell-off because the position is getting crowded and there are signs that Europe is pulling away from deflation (and a heavy dose of QE probably won’t hurt the cause). He does expect FX vol to stay high, but says that investors need to be careful when choosing currencies ad strategies.

FX volatility