Inside Investment: The bear market in volatility

Nostalgia is all the rage in the pop music world. The Specials reformed in 2008, The Stone Roses in 2012 and now indie rock icons The Libertines, who split acrimoniously in a fog of narcotics and recriminations in 2004, will play London’s Hyde Park this summer and then tour Europe. In the same spirit – unfogged – I was flicking through the Inside Investment back catalogue and came across an article from January 2007 called ‘The strange case of volatility’.

It looked for explanations for why the VIX index of volatility, known as the Wall Street fear gauge, was languishing at lows around 11. Wind the clock forward seven years and the VIX is now around 11 and nudged lower in June. In both 2007 and now the decline in the VIX was accompanied by rallying stock markets. The S&P500 peaked in October 2007 at its highest level since the TMT crash in 2000 and has recently reached a new record high.

The VIX has yet to reach a record low. But, it has only closed in single digits eight times since 1990. The JPMorgan global FX volatility index is at decade-long lows. The world’s most actively traded cross – US dollar/euro – has languished in a 1% trading range since March. Bank of America’s Market Risk Index is back to levels last seen in (you guessed it) 2007.

Back in 2007 this column asked whether one explanation of declining volatility might be central banks. The accumulation of foreign exchange reserves had been remarkable. Between 2000 and 2007 the International Monetary Fund’s Cofer database recorded a rise in FX reserves from $1.8 trillion to $4.7 trillion. That gave central banks greater firepower than ever to intervene in markets and dampen volatility.

Added to that, the style of central banking had changed. Transparency and clearly articulated goals were the new order. That made it easier for markets to second-guess policy moves. The ‘Greenspan put’ also meant that when the world’s setter of global monetary conditions was faced with volatility in asset prices, there would be a direct policy response.

The accumulation of foreign exchange reserves between 2000 and 2007 was largely an emerging markets phenomenon. The corollary this time around has been G4 balance sheet expansion. The numbers are even bigger. The Bank of Japan, US Federal Reserve, ECB and Bank of England have aggregate balance sheets accounting for almost 30% of combined GDP. The size of these balance sheets has trebled since 2007.

Rhyme and reason

Policy has been quite coordinated and so, with leaders and laggards, has been the response of the real economy. The volatility of growth among the main industrial nations is at its lowest level since, wait for it, 2007. It is half the average since 1987. As the quote often attributed to Mark Twain says: “History may not repeat itself, but it does rhyme.”

Across the G4, policy has certainly been dancing to the same rhythm. Policy rates have been slashed to zero. The Federal Reserve and Bank of England were early to the quantitative easing party in 2008 and 2009 and the Bank of Japan joined in very enthusiastically in 2013. Its aim is to double its already bloated balance sheet through asset purchases. The ECB has raised QE as a possibility, but the negative deposit rate and €400 billion in TLTROs, is unconventional policy by other means.

Markets also rhyme with 2007. CLO issuance has hit a post-crisis peak; 80% of fund managers believe high-yield debt is overvalued, but deals are oversubscribed by multiples of five, six and seven; lending standards are declining with cov-lite and PIK bonds making a comeback.

Greek banks have been issuing at rates below the sovereign ceiling. A recent Piraeus Bank rights issue was sold to UK and US investors; the European roadshow proved surplus to requirements and was cancelled. The conclusion of the 2007 article was that volatility would rise with, “something likely to emerge from the swamp of structured credit”.

We are not quite back to those good old, bad old days. But it feels eerily familiar. If anything can destabilize the Great Moderation MkII and market melt up, it is likely to be policy. The Fed taper began last summer. The Bank of England has held the stock of QE constant at £375 billion since late 2012. QE represented unconventional monetary intervention by the last balance sheet standing: the central banks. There is a sense that the ECB’s actions last month are also the last role of the reflationary dice.

For the next few months, G4 policymakers are likely to stick with their default settings. But since Bank of England governor Mark Carney’s volte face at his Mansion House speech, investors are beginning to realize that central bankers still have the capacity to surprise. Markets are now pricing a November 2014 UK interest rise at a probability of 50%. Emboldened by my successful prediction seven years ago, I would price the probability of a rise in volatility even higher than that.