Thoughts on the Mysterious Low Volatility in the Capital Markets

One of the most stunning facts about the investment climate is the unusually low volatility throughout the capital markets. The reason that is increasingly worrisome, is not just because trading profits of the major banks suffer or that hedge funds find it difficult to make money.

The reason is that low volatility is seen as a harbinger of doom. As the NY Fed's Dudley put it recently, "Volatility in markets right now is very low. I am nervous that people are taking too much comfort in this low volatility period, and a consequence of that, taking bigger risks."

It may seem ironic that Dudley expressed concern about volatility as according to some, the Federal Reserve (and other parts of the government) are responsible for it. Gillian Tett of the Financial Times expressed the views of many when she wrote that "markets have been so distorted by heavy government interference since 2008 that investors are frozen."

Dudley is worried investors are taking too big of risks and Tett is worried that investors are not fully participating. It is not clear how the lack of desire to invest leads to record high stock prices. Alternatively, if the Fed is interfering too much, why would the US bond market rally as it reduced its interference through tapering its purchases. Moreover, the policies (interference) have been in place for some time and volatility only recently has fallen.

Nevertheless, the low volatility is cited as evidence that the capital markets are not pricing in macro-risk. Investors, so goes the argument, have become complacent. This conclusion may be a function of confusing net positions with gross positions. Consider that in late May, the gross short speculative position in US Treasuries was 529k contracts, the highest since 2007. At the same time, the gross long speculative position stood at 432k contracts, which is the highest in over a year and only surpassed a handful of times since 2008.

The euro, whose resilience in the face of Fed tapering has been unexpected, saw relatively large gross positions. In the middle of May, for example, both the gross long and gross short positions were above 52-week moving averages though the net position was relatively small. Large gross long and short positions, as in the Treasuries and euro do not speak to the traders being "frozen" as Tett suggests or taking bigger risks as a whole as Dudley fears.

Much of the discussions about volatility seem to pretend it is neutral to market direction. It is not. Volatility has fallen as stocks have risen. Volatility has fallen in the bond market as bonds have rallied. Euro-dollar volatility has fallen as the euro has risen. In fact, over the past month as the euro has been pushed down, away from the $1.40 level, volatility has risen.  A call for higher volatility is a call for a stocks and bonds to sell off and for the dollar to appreciate.

This line of reasoning brings us to what seems to the crux of the matter. What is driving the markets? One line of reasoning that strikes a responsive chord for many, which Tett articulated, is that government policies are the main culprit. In some ways, this is a resurrection of the old argument since the early days of the policy response to the crisis. There have been countless doomsday scenarios proposed by those who of opposed a strong government, including central bank, response. It would lead to hyper-inflation; they cried. It did not. It would lead to the US defaulting on its debt. It did not. No one would buy US Treasuries if not for the Fed and yet the private sector has shown a large appetite, with US bank holdings increasing by a dramatic 25% in the January-March period.

There is a reductionistic argument here. Low volatility proceeded the global financial crisis. There is low volatility now. Therefore, another crisis is lurking around the corner. Q.E.D. Yet, low volatility did not cause the global financial crisis. The lax regulatory framework and enforcement, excessive leverage and what was traditionally understood as off-balance sheet exposure, now called "shadow banking", played an important role in other narratives of the crisis. To varying extents, policy makers have tried to address some of these issues through boosting capital requirements and other regulatory issues. Some who do not like these measures call it "financial repression", but it is really meant to address the excess laxity of the previous period.

In conclusion, we see the recent discussions of the low volatility of the capital markets as confusing several issues. First, the complaints seem to be contradictory. Is it leading to greater risk taking or is it freezing investors? Second, the focus tends to be on net positions, which conceals the insight offered by examining gross positions. Third, the decline in volatility does not line up well with the government interference arguments. Fourth, volatility is not neutral relative to market direction. Fifth, the doomsayers may be crying wolf yet again. Low volatility did not cause the global financial crisis, and while efforts to deter another one may contribute to a decline in volatility, the excesses that are associated with the financial crisis, such as extreme leveraging and opaque off-balance sheet exposures do not appear present now.