Perhaps today is not the most exciting time. The financial market becomes boring when it becomes profitable. The S&P 500, the barometer of the US economy, is in the longest growth band in its history without a 5% rebound.
Bond yields have risen slightly in recent months, but are still at the bottom of historical ranges.
Companies known for their trading prowess (such as Goldman Sachs) record a decline in profits due to an overly calm market.
The most robust monetary policy since the financial crisis has virtually eliminated market volatility.
Central banks keep short-term rates low and intervene to lower bond yields through quantitative easing (QE) programs.
The classical pricing method for financial assets implies that they have a discounted value for future cash flows.
As central banks maintain a stable discount interest rate, prices also remain stable.
American economist Hyman Minsky argued that long rises sow the seeds of their own collapse. He said that when the economy is doing well, investors are more likely to take on additional risk (for example, gaining more debt).
These speculative positions are vulnerable to such a shock as a sudden increase in interest rates, which could turn into a full-fledged crisis.
With a highly competitive market, speculators are not limited to equity or even borrowed funds to buy assets to place bets. They can use derivatives to bid on prices.
Sustainability of the S&P 500 indicates that actual or realized volatility remains low.
But investors can also hedge against a sharp movement in the stock market (in any direction), taking an option that gives them the right to buy or sell shares at a given price for a certain period.
The price, or the fees they pay for this option, includes many factors. But one of the most important is how volatile investors predict the future market.
This measure is nothing but the “implied” market volatility and the basis for the VIX, or volatility index, notes The Economist, a British magazine.
Speculators who believe that the market will remain calm can sell options for volatility, earning a premium income. The more sellers, the more the price or premium drops (and VIX becomes lower).
The threat is that a sudden increase in volatility can lead to losses for speculators.
In this regard, investment banks resort to such a well-known indicator as “value at risk”, to determine the size of their trading positions, a decrease in volatility pushes them to a greater risk.
Since volatility tends to increase when asset prices fall, this could lead to a wider financial crisis.
Two new studies by the Federal Reserve Bank of New York analyze this issue in detail. The authors indicate that low volatility tends to remain stable; past data show that long periods of calm are interrupted by short bursts in the form of a crisis.
Therefore, low volatility today is not necessarily a warning sign.
Researchers write: “As a rule, extremely low volatility predicts low rather than high volatility in the future.”
However, VIX measures “implied” volatility for only one month.
You can also calculate the “implied” volatility for a two-year period by creating a curve by the type of yield curve that measures interest rates for different loan terms.
Back in 2006-2007 this volatility curve was very flat, which inspired incredible optimism in investors.
Perhaps that is why so many players have problems in the subprime mortgage market.
Today, the Fed says that the volatility curve is steeply tilted up (since 1996, the tilt has been steeper than just 15% of the time). This suggests that investors are not feeling calm and are expecting volatility to return soon.
Investors seem to believe that VIX could reach 20% (compared to about 11% today) in the next year or two years.
The obvious catalyst for such changes is monetary policy. The Fed raises interest rates and slowly spins quantitative easing; The ECB is curtailing the purchase of bonds.
Until now, this process has not raised much concern. But a turning point can occur when higher rates will create problems for both investors and borrowers.
In any cycle, there is always some kind of institutional investor who takes a greater risk than the rest. If the storm breaks out this year, the world will find out who was in bad weather without a cloak and an umbrella.