SAFT ON WEALTH: Who ate the market volatility?

December 13, 2012

Dec 14 (Reuters) – For an uncertain world – one with fiscal
cliffs, eurozone recession and regime change at the Federal
Reserve – it sure is quiet out there.

Volatility in financial markets is now trading more like we
are in the pre-crisis world of 2006, rather than one in which
most of the crucial questions are left unanswered.

Sometimes called the fear index, the VIX which
gauges investor perceptions of how jumpy the S&P500 stock index
will be in the coming month, is now trading at around 16, more
than 60 percent below its 2011 peak and not too far above its
median level for the past century. In fact, if we get through
December without a major market upset, 2012 will be the first
year in seven without a significant spike in the VIX.

In theory this should be very good for riskier assets, as
volatility has a nasty habit of flushing out investors. But in
practice the outlook for 2013 may hinge on whether the forces
suppressing volatility can keep the market placid.

To figure out the likelihood of that, you have to answer a
question: is the low volatility a return to normal, perhaps
supported by changes in the structure of markets, or are markets
being tranquilized by “quantitative easing” by central banks and
low interest rates?

If you believe, as I do, that volatility is low mostly
because central banks are dousing markets with liquidity, then
your call on next year is really a reverse call on the Fed’s
success. The conundrum is that we have people living as if there
will be tremendous volatility, and the dearth of capital
investment is the best example of this, but financial markets
pricing the world as if there will be very little volatility.

Analysts at investment bank JP Morgan have done an
interesting study summarizing exactly how out of whack
volatility markets are. They looked at 484 macro-economic
indicators which have a meaningful historical correlation to the
VIX and then ran a regression study comparing how they have
changed and whether that is reflected in the current VIX.

“Results show that the current low VIX level is in
stark contrast to virtually every macroeconomic indicator across
the globe,” Marko Kolanovic of JP Morgan wrote in a note to
clients. Specifically, if the VIX were trading in line with U.S.
indicators it would be more than 40 percent higher. If it were
being driven by European indicators it would need to be about 60
percent higher.


That’s not to say a spike is imminent. There are powerful
forces driving volatility lower, with many investors seeking to
piggyback off a generous Federal Reserve which only yesterday
pledged action that will expand its book of bonds by more than a
trillion dollars in 2012. Remember, that’s a trillion newly
created dollars seeking a home.

The Fed, of course, is doing this precisely to encourage
investors to come along for the ride. Federal Reserve Chairman
Ben Bernanke has been explicit about his hope that quantitative
easing drives money into riskier areas than mortgage and
government bonds. So far, it is working.

Hedge funds, according to Societe Generale, are massively
short the VIX, with the amounts being bet so huge they are more
than five standard deviations away from the average since 2005.
That makes for a once in a century or so event. Of course, most
of what has happened in markets and the economy since 2005 has
been a once in a century event.

Cullen Roche, of advisory firm Orcam Financial, believes it
is more likely the VIX will revert t o mean, arguing that a
20-year view shows room for further moves downward with fear
among investors still high.

“Wake me up when this index does something that sends us
shooting (in either direction) away from the mean. As opposed to
what looks like a big coin flip here…,” he wrote in a blog
post. (See: here)

And, to be sure, there have been big structural changes in
markets driving volatility lower. Equity trading is near
historic lows, with something over half of the trades that are
being made executed by high frequency traders or exchange-traded
funds, both of which tend to make stocks more highly correlated
with one another and reduce index volatility.

None of this, not the hedge funds or the HFTs or ETFs, are
powerful enough to suppress volatility without help from the
Federal Reserve. The Fed, as it explained yesterday, is going to
keep its foot on the gas until unemployment hits a threshold of
6.5 percent or inflation shows signs of moving too high.

If the economy heals rapidly, or if inflation shoots higher,
the result could be a burst of volatility, as all the power that
has been long suppressed breaks out. That means great news for
jobs in 2013 – a real but small possibility – could be lousy
news for financial markets.

(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at and find more columns at

(James Saft)

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