Hurrah for low volatility, a sign of saner markets

June 10, 2014

By Edward Hadas

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Traders are moaning about the extraordinary calm which has beset financial markets. Everyone else should be happy at what looks like an inadvertent outbreak of common sense. If only it could last.

The VIX is the bellwether. The index of implied volatility of U.S. stocks is close to an all-time low, having fallen from 14 to 11 since April. It was 80 at the peak of the financial crisis in 2008. But similar placidity is found in the major foreign exchange crosses, in bond markets and in commodity prices. In some markets, the relative inaction is not merely daily. The price of oil and the euro-dollar exchange rate have been unusually stable for the last few years.

Equity market volatility

The calm might presage a storm. The last time equity volatility was this low was 2007, shortly before the financial world fell apart. And now investors are expecting a sea-change in the financial world, as U.S. monetary policy tightens.

However, that explanation misses something important. Eight years ago, markets were abuzz with the Great Moderation, the expectation that steady growth and easy financial conditions would last forever. This time around, no one is confident of anything. Indeed, it is more likely that the markets’ inaction signifies nothing about the future.

The most likely cause of stability is a technical factor which doesn’t flatter the financial community. The banks that provide most of the funding for active traders are under capital pressure. They are holding back and the buyside is responding by making fewer bets.

The result is less activity, less volatility and a greater correspondence of markets with reality. After all, financial markets typically move around much more than rational projections of either the economic or financial future. Soporific trading looks like a diminution of the bipolarity, the alternation of greed and fear, which makes markets fun for participants and ludicrous for more dispassionate observers.

Sadly, the calm is probably temporary. Traders will regroup and become more active once they adjust to the new funding environment. And whenever economic reality does change sharply, investors can be counted on to overreact.

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