We increasingly see claims low volatility in the markets may be structural. Even as we agree that some of the analyses we see make good points, we are concerned we may be setting ourselves up for a major shock. Let me explain.
Before getting into the details about the current environment, let me make some general observations. In my experience, complacency, with its cousin low volatility, is the best bubble indicator I am aware of. Perceived safety gets investors to pile into investments that they later regret. When it happens on a massive scale, major market distortions may be created that can lead to financial crises. And as the tech bubble that burst in 2000 shows, even if there is no systemic risk, the unwinding can be most painful to investors. In 2008, however, the perception that home prices always had to rise had become engrained in highly levered, yet illiquid, financial instruments, causing the unwinding to bring the global financial system to its knees. In our assessment, however, make no mistake about it: assuming for a moment the next crash won't take down a major bank, doesn't imply it cannot wipe out much more of your wealth than you ever anticipated.
Indeed, lower bank leverage is given as an argument as to why volatility is lower these days. Except that the run-up to the financial crisis of 2008 - a period in which banks were extra-ordinarily levered - also showed low volatility in a variety of markets. It was the perceived safety, embodied by quasi-sophisticated value-at-risk (VAR) models that got risk managers at financial institutions to gear up. What could possibly go wrong, right?
A more convincing argument I hear as to why low volatility is structural may be that information nowadays gets absorbed more quickly. On the one hand, we have computers scan the news in milliseconds, often trading without human intervention. And we have more computing power, allowing for a more efficient implementation of any investment process. Market makers in exchange traded funds also help in the execution efficiency of markets, possibly exerting downward pressure on volatility. However, let's not forget that volatility lowered in this fashion may have the same implication as low volatility in the building up of any bubble: it is the perceived risk that is lower, not actual risk. Machines are fantastic at certain aspects, be that keeping spreads tight in an exchange traded fund, or scanning Twitter for keywords. Trades initiated in this fashion provide liquidity to the markets, but that liquidity can evaporate rather quickly when the machines go off-line. Let there be a glitch in the markets for whatever reason (say, someone dumps a large number of derivatives in off hours), and today's incarnation of automated traders tend to wait it out. In the meantime, stop loss orders of other market participants may be triggered, possibly causing flash crashes.
One argument is that low volatility is due to a lack of economic surprises. We get emotional about elections, but when the economy is stuck in a low growth environment with few deviations, it only makes sense for markets to be less volatile as well. That may be the case, but in our assessment won’t stop from investors pushing asset prices to unsustainable levels on that backdrop.
I have little doubt that a substantial driver of low volatility may be central banks. Low interest rates and quantitative easing (QE) compress risk premia; in plain English, this means not only that junk bonds trade at a lower premium over Treasuries, but that perceived risk is reduced in all markets, including equities, causing volatility to be lower. When central bankers "do whatever it takes," it is no surprise that investors chase yield without being concerned about negative consequences.
But when central bankers "taper" their purchases, odds are that volatility comes back as taper tantrums have shown. The same should be the case when the Fed raises interest rates or "normalizes" its balance sheet. But wait: this hasn't happened, emboldening those who argue we have a structural change. With all due respect, I believe this is the wrong conclusion: in 2016, the Fed was hostage of the markets. Eager to raise rates, the folks at the FOMC realized they could only raise rates if the market let them. Any Fed official will tell you they won't be held back from raising rates simply because equity prices might fall. Indeed, any incoming Fed chair (and we will have a newbie early next year) will take the job with the best of intentions, not be bossed around by the markets. Except that falling equity prices are often associated with expanding risk premia, i.e. plunging junk bonds; that is, they are associated with deteriorating financial conditions. And the Fed is always ready to respond to “deteriorating financial conditions.” You tell me what the difference is in an era of elevated asset prices.
Still, the market appeared to present the rate hike earlier this year on a silver platter. Just as a bull market makes investors feel very smart, a rate hike where the wheels don't fall off the markets makes the guardians at the Fed feel like they are doing their job properly. Maybe so. I have a more somber interpretation: in hesitating so long to raise rates, the Fed has fallen ever more behind the curve. Sure, the Fed may raise nominal rates, but real rates may continue to be low to negative. Federal Funds futures currently price in 2.5 more rate hikes until the end of 2018, including the one we are expecting today (we write this analysis before the June FOMC decision). How is that possible with an economy that is allegedly booming, where wage pressures, albeit not severe, are gradually creeping higher? As such, my sanguine interpretation is that the reason the market is not spooked is that it thinks the Fed is going to stay "behind the curve."
As a word of caution, with a new Fed chair coming next year, I would not count on the market being complacent; the new chair may well try to assert himself or herself, causing risk premia to rise. The pressure cooker may well try to release steam once again, until the Fed chair then reacts to what may well be deteriorating financial conditions.
This implies the Fed won't be able to normalize its balance sheet, but is more likely to be heading towards QE again. Indeed, my interpretation of FOMC talk is that many members believe more QE is not a question of whether, but of when.
If my analysis is correct, it suggests low rates for a very long time. And that, in turn, may of course mean that risk premia will ultimately be compressed yet again. So, maybe, it is different this time?
Let's look at equity investors. The brilliant minds (brilliant because they have made lots of money in recent years, please take this reference as being cynical) know that central banks will come to the rescue. So why not buy the dips? And stock prices always go up, don't they? You can't possibly be smarter than the masses (the index), and the index is going