In its February 2015 edition of the Markets Monitor, the Office of Financial Research highlights that “In recent months, volatility in key asset classes has approached or exceeded long-term average levels amid plunging oil prices, sizable currency moves, and divergent monetary policies.”
The report goes on to discuss whether this is “an enduring normalization of volatility”, and the consequences for markets and investors if volatility does become the new normal for 2015 and beyond.
Volatility is up across nearly all asset classes
The OFR report notes that volatility is up notably since late 2014 for almost all major asset classes, as oil prices have nosedived, the U.S. dollar moved up smartly, and central banks announced major and diverging policy actions (see Figure 1). Furthermore, option-implied volatility is close to or above long-term average levels for U.S. Treasuries, U.S. equities, currencies and commodities, with volatility across the board like this not seen for over two years.
How tail risk funds work
Tail risk funds have gotten a lot of attention since the sudden selloff that struck the markets in March, so many wonder how they work. Several tail risk funds reported returns in excess of 1,000%, causing questions about how such a return is even possible. It has to do with the way they go about Read More
In fact, realized volatility is arguably even higher than option-implied volatility, a very rare happening that highlights a divergence between projections of future volatility and current asset price dynamics. The report also points out that: “The term structure of volatility and skew (demand for protection against asset price declines) have also started to normalize.”
Oil price crash major factor is cross-asset volatility
The report argues that the huge drop in crude oil prices in the second half of 2014 is a “primary driver of increased cross-asset volatility.” Of note, oil were down over 50% in the last six months of 2014, though prices have bounced back a bit given data showing tightening supply. This downturn in oil prices is projected to last for a while, as supply looks set to continue to exceed demand for at least the next several months. In fact, the West Texas Intermediate oil futures curve is projecting that the price of crude will stay under $70 per barrel over the next five years.
It’s clear that volatility in oil prices has led to increased activity in broader markets. Long-term U.S.Treasury yields were up significantly February, although still at historically low levels. The recent uptick in oil prices and a stronger-than-expected labor market report are two factors related to this move as market-implied inflation expectations were basically unchanged at low levels. Moreover, market-implied interest rate expectations are also much more restrained than median Federal Open Market Committee projections.