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Markets Seem Fearless as Volatility Sinks
Summary:
Call it the calm after the storm.
Following the pandemic-driven hurricane that battered the global economy and world markets, investors find themselves sailing in eerily calm waters.
Key measures of implied stock, bond and foreign exchange market volatility are tumbling, in some cases to levels last seen before the COVID-19 outbreak more than three years ago.
The 'VIX' index of implied volatility in the S&P 500 - the Wall Street 'fear index' - this week fell below 14.0 for the first time since February 2020. The average over the past 20 years, and since the index's launch in 1990, is just under 20.0.
A benchmark global FX implied volatility index fell to its lowest level since February 2022, and the 'MOVE' index of implied Treasury bond volatility is the lowest since before the U.S. banking shock in March. Both are well off recent peaks.
Despite monetary tightening cycles that have lifted interest rates in many countries to their highest in decades, markets are booming - French and German stocks just hit record highs, Japanese equities climbed to a 33-year peak, and an AI-led tech frenzy is juicing Wall Street higher.When you consider the U.S. banking turmoil, U.S. debt default scare and liquidity withdrawal fears that dominated headlines in recent months, the slump in volatility is in many ways remarkable, and begs the question: how long can the stars stay aligned?
But it is also perfectly reasonable.
Soft Landing
The Federal Reserve is near the end of its rate hiking cycle, even if it may have one or two quarter-percentage-point hikes left in the tank. Interest rate futures market pricing has the year-end policy rate roughly where it is now, and lower in 2024.
Barring unforeseen shocks, a hawkish U.S. central bank is not something investors have to factor into asset prices over the next six months and into next year. That's a potentially remarkable period of interest rate stability.
That's especially important for currency markets. Exchange rates are driven by the concertina effect of cross-border interest rate differentials - the more stable and less volatile they are, the more stable and less volatile FX markets are.
The U.S. economy is still growing and the unemployment rate anchored near 50-year lows. While there will almost certainly be bumps along the way after the most aggressive rate hiking cycle in 40 years, the 'soft landing' narrative - in which the economy and inflation slow without triggering a recession - is gaining traction.
In a survey of hundreds of attendees at a Deutsche Bank European Leveraged Finance Conference in London this week, some 28% said the U.S. recession, when it comes, will be "inconsequential" in nature and for markets.
Gimme Shelter
In a JP Morgan client survey this week, 29% of respondents said a "soft landing" scenario is the main reason equity volatility is so low, and 35% pointed to "low investor positioning."
Several positioning surveys and data show that investors are underweight equities, in some cases holding their lowest allocation in many years. At the same time, their cash and bond holdings are the highest in years.
So with the stock market going up, investors have little need to hedge their equity positions because their exposure is so light and they are already 'naturally' hedged by being long cash and fixed income. Demand for downside protection via S&P 500 options contracts then dries up, and as the VIX index is derived from these options, implied volatility sinks.
None of this suggests investors should be complacent. Intuitively, when volatility is so low the chances of a snap higher increases, leaving a broadly unhedged investor base vulnerable.
Buy-The-Dip BonanzaResearch by Nautilus shows that when the VIX breaks below 14.0 for the first time in over a year, the S&P 500 tends to struggle. There's an 84% probability the market is down a month later, a 68% probability it's down after two months, and a 62% probability it's down three months later.
But as long as investors are in 'BTD' and 'FOMO' mode and 'buy the dip' for 'fear of missing out,' volatility can stay low and in turn limit the downside. This has been evident in short-term trading strategies recently as much as longer-term investment positions.
As Bank of America strategists note, even during last year's selloff, markets still tried to rally, only to be beaten down by Fed rate hikes - the median up day for the S&P 500 last year was the highest since 1938.
So far in 2023, 'buy the dip' strategies are having their third-best year ever as the end of the Fed's cycle comes into view. Until the 'long and variable' lag of previous tightening kicks in, low volatility could keep that going for a little longer yet.
Source: ZAWYA
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