Low volatility sounds like a good thing in markets. And it can be, unless it’s masking or ignoring problems. The real trick is preparing for an end that can be quick and unpleasant.
“Volatility rarely picks up bit by bit. It tends to spike when the late-cycle bullish narrative goes off the rails,” Cantor Fitzgerald LP’s Peter Cecchini wrote in an email.
Price swings are exceptionally depressed across assets now, with major central banks displaying relative policy clarity, signs that China’s stimulus is working and global economic growth that appears to be easing instead of falling. The MOVE index of Treasury volatility isn’t far off its March 20 record low, while the JPMorgan Global FX Volatility Index has fallen to levels not seen since 2014. The Cboe Volatility Index, or VIX, reached its lowest point since October on Friday.
But Morgan Stanley’s Andrew Sheets is one of the strategists warning that the calm won’t last.
“If the Fed stays dovish and the data weaken, volatility will go higher,” Sheets said. “If the data pick up and central banks are effectively saying we’re not going to tighten in the face of improving data, wouldn’t that generate a lot more risk-taking behavior? That would be volatile too.”
Last February was an example of a move that caught markets by surprise. The VIX stayed unusually low throughout 2017, lulling investors into a false sense of complacency. When volatility did pop during a meltdown -- the VIX skyrocketed to close Feb. 5 at 37.32 -- it left some short-volatility products broken beyond repair.
Potential triggers for price swings include factors like a worsening of global trade relations, a return to hikes by the Federal Reserve, an economic downturn or a geopolitical shock.
“U.S. employment always looks best right before recession, and the U.S. data has had the benefit of massive fiscal stimulus from deficit spending (not likely to end soon) and from tax cuts (benefits in the rear-view mirror),” Cantor’s Cecchini said.
Liquidity is also cited as a concern by Sheets, JPMorgan Chase & Co.’s Marko Kolanovic and Societe Generale SA strategists led by Vincent Cassot, who maintain that low liquidity will worsen volatility once signs of trouble start to emerge.
Then, there’s the question of what to do about this all-but-certain jump in volatility.