“If there are two words in the Ferrari vocabulary that get the blood flowing in any tifoso, surely those words are ‘California Spider,’” proclaimed the silver placard next to the maroon 1959 sports car.
“What’s a tifoso?” I asked the scarlet miniskirted Ferrari saleslady.
“A fan,” she said. “Like a soccer fan. At the World Cup.”
“Ah. And just how much is that Spider?” I inquired.
“If you have to ask how much a Ferrari costs, you can’t afford it,” interrupted a lady of a certain age who was standing next to me, peering into the car window. “You really can’t.”
Of course she was right. I looked up the most recent sale of a 1958 Spider on my iPhone: $8.8 million.
Sports car and Manhattan real estate values are both soaring out of my price range. Looming over us was Rafael Viñoly’s 432 Park Avenue condominium tower, being built into the clouds just one block north of the Ferrari dealer, heading for 96 stories. Vanity Fair gushed over fact that the penthouse had sold for $95 million in an article titled “Too Rich, Too Thin, Too Tall?”
About the only thing headed down is volatility. “The VIX has fallen down, and it just can’t get up,” a Connecticut-based macro trader e-mailed me, referring to the Chicago Board Options Exchange’s index of implied volatility of options on the Standard & Poor’s 500 index. The VIX isn’t alone. The decline in volatility of prices across a whole range of traded assets, from equities to fixed income and commodities, is the single most striking feature of the past six months in global financial markets. “It’s hard to make money trading when markets are so happy and placid,” complained a global macro trader in the City of London. Many a hedge fund manager is desperate to find some alpha to beat the smoothly appreciating benchmarks, and alpha opportunities almost always come paired with volatility in the hedge fund world. So what could make it go back up?
Vol has a long way to climb back. A graph of the VIX resembles a north-south slice of the Himalayas, topping at Sagarmatha and K2 heights of 48 in mid-2011, then sloping down through various foothills to a placid Ganges low of around 11 today.
| Vanishing VIX: CBOE Volatility Index |
The Economist mocked this apparent calm as the “Sea of Tranquillity” in a late-May article, when it warned that “volatility has disappeared from the economy and markets. That could be a problem.” The curious absence of volatility was the most striking take-away from the annual conference of three dozen global macro traders and strategists that gathered at Oxfordshire’s Ditchley Park in May. You would be equally appropriate arriving at the elegant entrance of Ditchley’s 18th century manor home in your California Spider or your coach-and-four with bewigged footmen.
Throughout the technical discussions and the sipping of champagne in Ditchley’s stately rooms ran a consistent thread. As one London-based trader put it, “Vol is curiously, distressingly low.”
Notwithstanding their anxiety about the missing vol, most of the Ditchley participants see this tranquility continuing, at least through the balance of this year. The majority of their peers in the market apparently agree. According to the results of a poll of global macro traders and strategists that I conduct every six months for Institutional Investor magazine, in June the mean forecast for the VIX at the end of 2014 is between 14 and 20, with 55 percent of respondents putting it in that range. There was only a 1 out of 5 bet that the VIX would break through 20. The lowest value any single trader assigned the VIX between now and December 31 was 8; the highest, 32. In other words, the clear majority believe the easing of volatility will continue at least for the next six months.
Four different explanations for the subdued behavior of financial markets emerged from the Ditchley discussions. First, central banks are artificially suppressing volatility by pumping in vast amounts of liquidity. Second, systemic risk has been drained from the global financial architecture by deleveraging, recapitalization and improved prudential regulation. Third, the simplest explanation, is the economic macro cycle: We are still early in the recovery cycle, where vol is historically low. A fourth hypothesis is politics: We actually live in a generally safer and more predictable world, so vol continues to ebb accordingly. There were relatively few takers of this last proposition at Ditchley, yet it is curious indeed that with Iraq and Syria going up in flames, heavy fighting in eastern Ukraine, chaos in Libya, choreographed clashes in the South China Sea and a string of increasingly brutal terrorist attacks in an African arc ranging from Nigeria to Kenya, the mean bet is for volatility to keep easing.
Let’s examine these four explanations of low vol and explore what events might sustain — or reverse — the trend.
Central Banks and Antifragility
The first Ditchley hypothesis centers on central banks’ sustained injections of liquidity into the international financial system since the 2008–’09 financial crisis, which advocates believe have artificially suppressed normal market volatility.
“Low volatility ex ante or ex post is not a bad thing,” says Michael Hintze, founder and CEO of London-based hedge fund CQS. “The problem is that we’re not in a low-volatility environment because markets have decided this, but because central banks have led us there. Central bank intervention papers over all the cracks, and it takes away diverging views.”
“The central bank monetary policy arsenal has brought peace to the markets,” Bhanu Baweja, global head of emerging-markets cross asset strategy at UBS, wrote in a recent research note. “All volatility buyers have been sought out and paraded to their graves. The resistance, it seems, has ended.”
Financier-philosopher Nassim Taleb sees similar forces at work, with potentially devastating consequences. “The problem with artificially suppressed volatility is not just that the system tends to become extremely fragile; it is that, at the same time, it exhibits no visible risks,” Taleb wrote in his recent book, Antifragile: Things That Gain from Disorder. “Also remember that volatility is information. In fact, these systems tend to be too calm and exhibit minimal variability as silent risks accumulate below the surface. Because players are unused to volatility, the slightest price variation will then be attributed to insider information, or to changes in the state of the system, and will cause panics. When a currency never varies, a slight, very slight move makes people believe that the world is ending.”
A clever paper for the 2014 US Monetary Policy Forum, organized in New York earlier this year by the University of Chicago Booth School of Business, put a sharp empirical point on Taleb’s argument. A talented team including JPMorgan Chase & Co. chief U.S. economist Michael Feroli, the Booth School’s Anil Kashyap, Kermit Schoenholtz of New York University’s Stern School of Business and my Princeton colleague Hyun Song Shin tested the risks of destabilizing funds flows caused by central bank polices in a paper called “Market Tantrums and Monetary Policy.” They connect market structure with price movements in a continuous way, noting that “delegated investors such as fund managers are concerned with their relative performance compared to their peers,” mainly because “it affects their asset gathering capabilities” — a cruel fact of life for every trader striving to beat a benchmark.
Feroli and company theorize that “investing agents are averse to being the last one into a trade. Although this feature can sound innocuous, it can potentially set off a race among investors to join in a sell-off race to avoid being left behind,” which they then demonstrate with statistical analysis, clearly showing evidence of what they call “the sharp reversal of return chasing.”
“The central banks very much believe that they can control the exit and the unwind of these policies,” warns CQS’s Hintze. “But remember, their balance sheets have never been as large while at the same time private sector banks’ ability to absorb volatility has been diminished by regulation. The challenge is that if we’re all in the same trade, the exit will be incredibly crowded.” Baweja and company at UBS agree: “If there is a vol trigger that leads to even modest outflows from asset managers’ funds, the current liquidity configuration will amplify volatility.”
Several members of the Fed’s policymaking Federal Open Market Committee were in the room when Feroli and company presented their paper in February, though not, notably, chair Janet Yellen or William Dudley, the dovish president of the New York Fed. There was a bit of the-emperor-has-no-clothes in the meeting, with the scholars pointing out the next volatility risk could come from unleveraged nonbanks that had walked out the yield plank in response to zero interest rates, as the Fed had intended in starting quantitative easing in the first place.
So how does the Fed propose to deal with this new vol risk? Basically, as a prudential regulatory problem. “The nonbanks, the hedge funds and asset managers have become the transmission mechanism for monetary policy as the U.S. banks delevered, but the Fed was now saying, in effect, ‘Not our problem,’” says Mark Farrington, head of London-based hedge fund Macro Currency Group, who attended both the Booth seminar and the Ditchley meeting. “As usual, they were ready to fight the last war.”
Surprisingly, in their comments on the paper at the Monetary Policy Forum, both Fed officials basically agreed with the Feroli argument. Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, member of the FOMC and cautious hawk, conceded that “financial instability may not be associated with the usual suspects; we have to keep an eye on the nonbanks.” Then-governor Jeremy Stein, who left the Fed in May to return to Harvard University, also saw risks looming in the Fed’s exit strategy. “Monetary policy is fundamentally in the business of altering risk premiums such as term premiums and credit spreads,” he said. “So monetary policymakers cannot wash their hands of what happens when these spreads revert sharply. If these abrupt reversions also turn out to have nontrivial economic consequences, then they are clearly of potential relevance to policymakers.”
As the Fed tries to delicately dismount from the back of the liquidity tiger, what might cause this process to reverse the volatility low tide — and perhaps spar a more serious version of the “taper tantrum” of 2013?
The traders’ poll assigned a 28 percent probability that the yield on ten-year U.S. Treasuries, which closed at 2.48 percent on July 18, will “normalize” above 3 percent by the end of 2014, and an 80 percent probability, up from 71 percent in December 2013, that the yield will be above 2.5 percent. (The poll also gave an average 58 percent bet that the SPX index, which stood at 1,978.22 on July 18, will end the year between 1,800 and 2,100.)
None of the poll respondents and few of the Ditchley conferees think that a “taper tantrum” redux is likely in the next six months, but they caution that it will take the Fed quite a long time to climb down from its inflated balance sheet, and that forward guidance as a tool to substitute for reduced QE comes with its own risks. Feroli and company agree. “The events of the summer of 2013 have been called an anomaly by many observers,” they write in their paper. “The benign interpretation is that risks have been mispriced and that, over the course of the summer and fall, communication by the Federal Reserve has helped correct that problem.”
However, they caution, “the Fed may have succeeded in 2013 in convincing market participants that slowing the rate of bond purchases is a separate decision from decisions about the path of future interest rates. Hence a reversal in risk appetite that was beginning in the summer of 2013 has been deferred. However, our analysis suggests that whenever the decision to tighten policy is made, then the instability seen in summer of 2013 is likely to reappear.”
“There are three different potential sources of instability here that could cause an uptick in vol,” said a New York–based macro strategist at Ditchley Park. “Any single central bank could get it wrong as they scale back their QE purchases and try to shrink those swollen balance sheets. It is tough to correctly signal your intentions to the market when you aren’t sure yourself what you’re going to do. Nobody has ever tried to shrink a central bank balance sheet like this.” He took another sip of champagne. “The second risk of instability is between any two central banks, with, say, the Fed and the Bank of England shrinking while the Bank of Japan and, say, the ECB are going the other way and expanding their balance sheets. That’s a great recipe for FX volatility on a major scale.”
And the third, I asked? “Something breaks in the financial plumbing,” he said, nibbling a canapé. “It wasn’t built for this kind of stress, and nobody’s done this before.”
According to a recent report by Dominic Wilson, chief markets economist at Goldman Sachs Group, and colleague Julian Richers, “Last year’s ‘taper tantrum’ did lead to a spike in volatility, although the spike proved temporary. But there is a risk that front-end rate volatility could pick up if positive data surprises continue. It is not obvious how much this would affect other assets — equity volatility did not move much last year during the rate scare, but FX volatility did. However, a significant misstep from policymakers on the road to exit is arguably the other major source of risk and one that a higher NAIRU [nonaccelerating inflation rate of unemployment] could reinforce.”
Some traders believe that September 2014 may well be the witching moment, with the Fed likely to feel the need to articulate its rationale and criteria for a faster taper if better economic data roll in. Most Fed chairs get tested by markets at least once in the first year of their term. Yellen is unlikely to be an exception.
“If the recovery does strengthen, there are two scenarios,” says William White, chairman of the Economic Development and Review Committee at the OECD in Paris, former chief economist of the Bank for International Settlements and a Ditchley participant. “First, there could be an orderly financial markets adjustment — rates going up smoothly. Long rates would go up, yield spreads would remain tight, but with robust economic growth the markets will not crash. The other possibility is disorderly, which could be realized through many permutations. It could be the result of typical market overshooting, for example. There is a very long path until rate normalization, due to worries about inflation and fiscal dominance. It is unclear what the new rules for dealers and collateral inventory will do to the markets once rates start rising.”
Goldman’s Wilson and Richers agree. “Beyond fresh shocks, volatility could shift higher under two conditions in particular. The first is if we are closer than we think to the point where the unemployment rate becomes a binding constraint. The second is if the exit from unconventional policy and the ‘zero lower bound’ lead to a sharper rise in uncertainty about where rates belong. In that case, rate volatility could rise more sharply, with a potential impact on other asset markets.”
The second potential source of a volatility redux is the market friction between those central banks that are tightening, however gradually, and those that are expanding credit, such as the Europeans and — most dramatically — the Japanese.
The Ditchley Park conferees were unanimous in attributing Japan’s turning back from deflation and contraction to the first and second of Prime Minister Shinzo Abe’s arrows — fiscal stimulus from the government and aggressive QE by the Bank of Japan. They all believed that the BoJ would continue to inject liquidity into the economy and consume the lion’s share of Japanese government bonds (JGBs). The majority believed that the growth momentum would continue, and this is consistent with the June poll, which assigned a 43 percent probability that Japanese GDP will grow between 2 and 2.5 percent, and 31 percent that it would expand faster than 2.5 percent, which is even more optimistic than the December 2013 poll.
Looking beyond December 2014, however, not all were convinced that the BoJ could continue to monetize JGBs without, at some point, triggering a run on the yen. “In Japan there is still an 8 percent fiscal deficit despite debt to GDP having risen to 250 percent on the books, excluding further off-balance-sheet liabilities,” says one London-based macro trader. “The BoJ is overfunding new debt issuance by 160 percent; they are buying all new debt plus purchasing large amounts of old debt. I think Abenomics will backfire. It is difficult to tell a reasonable story about how the policy would work even with structural change. If workers think there will be inflation of 2 percent per year for 20 years, they will hunker down and stop spending to preserve wealth. And pension managers and bondholders will start demanding much greater yield. Pretty soon, I think all of Japan’s debt will have to be financed by the Bank of Japan. And if history is a guide, the situation could transmute from deflation to hyperinflation very quickly.”
A sort of corollary argument to the central bank excess liquidity explanation claims that the supply and demand balance for trading volatility has been kept off-kilter by all that free money sloshing around financial markets.
“The VIX curve is exceptionally steep, and puts on the VIX are cheap to fund as a result,” says Marcel Kasumovich, chief strategist at Tse Capital Advisors, a New York–based hedge fund. “Sellers of volatility have been rewarded handsomely in the past year, no matter how dangerous. It is evident in so many different areas, implicitly or explicitly. So we know the rise will be nonlinear when it happens. But it is exceptionally difficult to position for. Strategies that systematically short the VIX were down 63 percent in the past year and 99.6 percent since inception in March 1999. Demand for tail protection has been beaten out of the market — we’re back to the greed side of the cycle.”
The U.S. Office of the Comptroller of the Currency apparently agrees with Kasumovich. In its latest Semiannual Risk Perspective, published in June, the agency warns, “The longer volatility remains low, the more likely investors are to chase yields to maximize returns, often selling options that expose them to losses if prices drop suddenly, or taking on increased credit risk.”
What of the third potential risk of central bank liquidity — the untested plumbing? Charles Himmelberg, head of global credit strategy at Goldman Sachs, agrees that this may be a problem. “Regulations have also resulted in a major repiping of the financial system, which is still rapidly evolving. The new market structure is fully untested, making it difficult to know how it will respond during the next recession or financial crisis — a known unknown.”
Assessing this risk segues into systemic risk, to which we will turn in tomorrow’s installment.
See the next installment, “The Volatility Conundrum: Is It Lowest Before a Storm?”
James Shinn is a lecturer at Princeton University’s School of Engineering and Applied Science (jshinn@princeton.edu) and CEO of Teneo Intelligence. After careers on Wall Street and Silicon Valley, he served as national intelligence officer for East Asia at the Central Intelligence Agency and as assistant secretary of defense for Asia at the Pentagon. He sits on the advisory boards of Kensho, a Cambridge, Massachusetts–based data analytics firm, and CQS, a London-based hedge fund.
