Weekly Insights - Why is volatility so low?

The VIX, a measure of the expected volatility priced into options on US equities (also known as Wall Street’s “fear gauge”), dropped on Friday to its lowest level in five years at 13.5. Surely, this is at odds with the perception that market conditions re

The VIX, a measure of the expected volatility priced into options on US equities (also known as Wall Street’s “fear gauge”), dropped on Friday to its lowest level in five years at 13.5. Surely, this is at odds with the perception that market conditions remain highly volatile, as so many commentators suggest, and worries over Europe, China and the US fiscal cliff?

The main explanation is the fact that recent movements in US equities have been very subdued and the VIX is derived from short-dated option prices – it is a measure of the market’s expectation of 30-day volatility. As such, traders will use the very recent historical volatility to decide if the VIX is too high or too low. Over the past few weeks, daily volatility on US equities has been extremely low: 10-day volatility on the S&P 500 has just declined to 4.0%, close to the lowest levels of the past 10 years (the biggest daily move in this index over the last 2 weeks has been 10 points, or 0.7%).

Explaining why realised volatility is so low is perhaps a harder question, although on 30-day and 50-day measures there is nothing exceptional about current levels. US equities have had periods of calm and periods of panic in recent quarters.

The current period of calm would certainly reflect an easing of European fears following Draghi’s remarks, but it may also reflect a calming of nerves over US profits and economic growth coming off the back of the Q2 reporting season and some very recent better economic data. Maybe it also indicates that short-term investors are not positioned aggressively and therefore do not feel the need to hedge equity risk? Certainly, volatility-related hedging products have grown in popularity lately.

Or could it be that investors have become complacent about the riskiness of US equities? Low recent trading volumes may also be playing a role; and low volatility combined with low volumes could perhaps suggest a lack of conviction or strong disagreement at current equity market levels.

All these possible explanations are pure speculation. While low realised volatility persisted from 2004 to 2006, since the 2008/09 crisis, calmer periods have quickly been interrupted by spikes in volatility. With many macro risks still unresolved, it would seem likely that volatility picks up at some point over the coming months.

A final warning on speculating on the VIX. Those expecting a rise in the VIX will find the futures curve sharply upward sloping – in other words, buying volatility becomes much more expensive as soon as you extend the time horizon a few months. By recent history the curve is quite steep: January 2013 VIX futures are currently trading above 25. So investors using VIX as a fear gauge may also want to monitor the shape of the curve.

Weekly Insights - The search for yields

The global macro backdrop remains highly challenging, with growth concerns in China and the European crisis first and foremost in investors’ minds.

While investors remain cautious and nervous to commit to equities, zero interest rate policies in the US, Europe and Japan are inducing a flood of money into fixed income markets, forcing a compression in yields outside of peripheral European governments (click to see data).

With 5-year government bond yields below 0.6% in the US, Germany, Japan and Switzerland, investors continue to bid corporate bond yields lower. This has even been the case for financials, despite European financial share prices selling off once again. Moreover, in emerging markets, falling inflation and interest rate cuts have sent yields sharply lower in the past month. Central banks in China, Brazil and South Africa have cut interest rates recently.

This is in contrast to Spanish 10-yields, which have hit new highs above 7.5% on concerns over regional government financing needs. Greek risk is also back on the radar as the Troika visits Athens to review the bailout programme.

Meanwhile, corporate earnings reports are coming in thick and fast. In the US, earnings have been fairly resilient, with Bloomberg reporting that so far 67% of companies have beaten expectations, although analysts have revised forward earnings modestly lower.

In Europe, results announcements have brought mixed fortunes, with some stocks rallying sharply (e.g. Remy Cointreau, Akzo Nobel and Electrolux) while others disappointed (e.g. Alactel Lucent’s warning).