Is this the calm before the storm? Alan Ruskin, foreign exchange analyst at Deutsche Bank, believes it is. In a note penned by Ruskin and published today, the analyst opines that markets are currently in “freeze mode” in the midst of global uncertainties. However, as the central bank balance sheet picture changes and central banks begin to tighten monetary policy over the next twelve months, this quiet serenity will be disrupted.
- Low Vix Does Not Boost High Sigma S&P 500 Drawdown Chance
- VIX Manipulation Possible Based On Recent Settlement: Study
- 50 Cent Hedge Fund Manager Unmasked; Not Only Using Vix To Hedge
Beware central bank balance sheet normalization
We're currently in one of the (possibly the most) benign market environments of all time. The leading US indices have been hitting record after record and the CBOE Volatility index VIX, is currently below 10, less than half its long-term average of 20. It recently neared its lowest level ever, and according to data from Charlie Bilello, director of research at Pension Partners LLC, September was the quietest it has been for 30 years, based on daily volatility.
According to Ruskin, this could all be about to change and here's why: Over the next 12 months, the "combined expansion of all the major Central Bank balance sheets will have collapsed from a 12-month growth rate of $2 trillion per annum to zero."
Nobel prize winner Thaler recently commented that investors appeared to be in “freeze” rather than “flight mode.” Ruskin notes there are several reasons why investor “freeze” appears to be favored over “flight."
He writes that "there is the suggestion that many equity investors have entered at good levels and are capable of withstanding fairly sizable negative shocks." Also, the "global growth rate is itself just about frozen, " and finally, central banks have contributed to low volatility through at least three avenues:
"a) at its most extreme the BOJ have literally frozen JGB yields, while other Central Banks have been intent on keeping bond yields low; b) the ‘stock effect’ of QE, means that there is strong legacy influence of past unorthodox easing which stabilises the bond market even as Central Banks shift to tighten; c) the post 2008 asymmetric policy approach, to ease when risk is vulnerable, but not remove emergency accommodation on asset market ebullience, represented the globalisation of ‘the Greenspan put’."
These factors, Ruskin opines, have contributed to subdued equity and bond market volatility and there are now a few arguments for suggesting vol is very near its lower limits. The most significant of these is likely to be central bank balance sheet reductions:
"We only have only limited experience with the ‘stock versus flow’ effects of QE. 2018 will see the world’s most important Central Bank balance sheets shift from a 12 month expansion of more than $2 trillion, to a broadly flat position by the end of 2018, assuming the Fed and ECB act according to expectations. The QT that was feared surrounding the taper tantrum never happened in 2014/15, but will very likely occur in 2018/19.
As we look at what could shake the panoply of low vol forces, it is the thaw in Central Bank policy as they retreat from emergency measures that is potentially most intriguing/worrying. We are likely to be nearing a low point for major market bond and equity vol, and if the catalyst is policy it will likely come from positive volatility QE ‘flow effect’ being more powerful than the vol depressant ‘stock effect’."