Volatility Stays Low and Means Nothing

Volatility Stays Low and Means Nothing

Volatility is not extinct, but it is dormant

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It's not just the VIX that is low. Volatility (vol) is at multi-decade lows in many different asset classes. Commodities, emerging market stocks, Chinese equities, US and UK inflation, bonds markets in multiple countries are all pushing historical lows. Short positions on US equity implied volatility is more than twice the long-term average. So it has to snap back, right? Well not really. 

Economist John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent and that applies to volatility right now. It is low and has been for quite some time, but this may essentially be the new normal. Wehn then Federal Reserve Chair Ben Bernanke implemented Quantitative Easing ("QE") in 2008, many people thought it was the first program of its kind but he was actually borrowing a tool from the Great Depression of the 1930's. QE has also been used by Japan since 2007 so even though it was being called "unprecedented" at the time, there was a precedent. If a governmental body is controlling the flow of assets, they are also reigning in long-term volatility. Short-sellers of the VIX and other representations of vol have been making money for quite a while now and continue to sell as we hit record lows and that is likely to be where the problem lies. As the Fed begins to normalize the balance sheet vol is likely to normalize as well, but not necessarily snap back to its long-term averages. If global central banks are able to reduce their balance sheets slowly and convince the markets that this is not an event, then vol will also move slightly higher slowly and continue to hurt those traders that have bought it waiting for a snap higher. 

Can a snap happen? Of course, just ask North Korea their true military intentions and you will be able to predict when but for now, it is better to look at volatility the way residents near a dormant volcano look at the risk of their geological location. Prior to 79 AD, Mount Vesuvio was considered extinct. After it erupted destroying Pompeii, Italy. It remains the only volcano that erupted on the mainland of Europe in the last 100 years. Today most people think of Vesuvio as a delicious chicken dish. Chicken volatility may be next. 

 

 

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