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Unusually Low Volatility Can Be Dangerous for Markets

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The smoother the road, the faster people are likely to drive. The faster they drive, the more excited they are about getting to their destination in good, if not record time; but, also, the greater the risk of an accident that could also harm other drivers, including those driving slower and more carefully.

That is an appropriate analogy for the way unusually low financial volatility influences positioning, asset allocation and market prospects. And it holds for both traders and investors.

The lower the market volatility, the less likely a trader is to be “stopped out” of a position by short-term price fluctuations. Under such circumstances, traders are enticed to put on on bigger positions and assume greater risks.

What is true for one trader is often true for firms as a whole. Moreover, the approach is often underpinned by formal volatility-driven models such as VAR, or value at risk, that give the appearance of structural robustness.

Patient long-term investors can also be influenced by unusually low volatility, whether they know it or not. Expected volatility is among the three major inputs that drive asset-allocation models, including the “policy portfolio” optimization approach used by quite a few foundations and endowments (the other two variables being expected returns and expected correlation). As the specifications of such expectations are often overly influenced by observations from recent history, the lower the volatility of an asset class, the more the optimizer will allocate funds to it.

All this is to say that the recent decline in both implied and actual measures of volatility, including a VIX that recently touched levels not seen since 1993, is likely to encourage even greater risk taking both tactically and strategically, including bigger allocations to stocks, high yield bonds and emerging market assets. And both, at least in the short-term, will contribute to damping market volatility further.

None of this would be particularly remarkable if the decline in volatility was not coinciding with notable fluidity in the global economy on account of economic, financial, geopolitical, institutional and political factors. From the North Korean nuclear threat and the rise of anti-establishment movements to allegations of Russian meddling in elections and yet-to-be properly explained behaviors of some economic variables (such as productivity, wages and inflation), among many other developments, the disconnect with the exceptionally low levels of volatility is attracting greater attention, though seemingly few portfolio adjustments as of now.

What makes the situation even more intriguing is that the main policy instrument that has been used in recent years to repress financial volatility, unconventional monetary policy, is itself in transition. The U.S. Federal Reserve has stopped its quantitative easing program and now seems intent on normalizing interest rates, including at least two possible hikes in the remainder of 2017. It is also considering a program for an outright reduction in the size of its balance sheet. Meanwhile, the long-awaited economic strengthening in Europe is placing pressure on the European Central Bank to be less accommodating, raising interesting questions about the sequence of its QE tapering, forward policy guidance and interest rate hikes. The Bank of England is seeing inflation rise to its highest level in some years.

Left unattended, all this could lead to some unpleasant market outcomes — whose consequences would potentially impact excessive risk takers, with negative spillovers on  those who have been more careful. Fortunately, there is an orderly economic and financial way to reconcile the disconnects, and without derailing the gradual normalization of monetary policy.

As detailed in earlier articles, this process involves politicians enabling other policy-making entities, which have tools better suited to the challenges at hand, to deliver on their economic governance responsibilities. By achieving higher and more inclusive growth, such an overdue policy response would enhance economic prospects, allow for genuine financial stability, lessen the political pressures on economic institutions (particularly central banks) and help render national politics less toxic.

But if the needed policy response continues to lag, this period of unusual market calm would end up as another data point in support of the “instability hypothesis” of the U.S. economist Hyman Minsky – that is, the simple yet powerful idea that excessive stability breeds unsettling instability down the road.


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