One-month implied volatility for the euro/dollar rate has broken below 5%, while the VIX, one of the most frequently quoted measures of volatility is sitting at around 10, half its long-term average and around its second lowest level since February 2007.
But, while markets seem to be displaying almost no fear at all right now, (which is worrying in and of itself) central banks look as though they are beginning to sing with a slightly different cadence if not yet from a different hymn sheet.
Much of the blame for the lower-than-normal volatility can be placed at the feet of central banks that have built the wall of money currently propping up asset classes around the world.
But, as Natixis points out in its latest Daily Economic Roundup note, “some central banks are starting to take the measure of the risks associated to ultra-accommodating policies, with their communication now focused on the gradual exit from these policies.
This, they argue, is the case with the Bank of England and the Federal Reserve in the US, both of which are doing nothing to dispel talk of rate hikes in their respective jurisdictions.
“While aware of the risks associated to ultra-accommodating policies, central banks are not ignoring the potential impact of their exit strategies on economic growth… All is happening as if central banks, having come to the realisation that the cures applied for more than five years have potentially rather dangerous side effects, are looking to stop the treatment while attempting to minimise the risks of the weaning process.”
This is further complicated by the likelihood that central bank policy is going to begin to diverge.
As Insight Investment points out in its latest Absolute Insight note, while the theme for the year was supposed to be interest rate normalisation across the developed world, this has not yet happened.
“As markets enter their summer torpor there are reasons to be fearful,” it says.
“We believe central bank policies will diverge. Tapering by the US Federal Reserve against looser policy from the ECB is just the beginning. The Bank of England has even hinted that policy rates will rise and markets are pricing a 50% probability of an increase as early as November. Those that remember 2007 will recall all too well that lightning can strike from a clear blue sky.”
On the other hand
JP Morgan Asset Management global market strategist, Kerry Craig, is less concerned, arguing earlier this month that fears of a ‘summer swoon’ appear unfounded despite the seeming contradiction between the low volatility present in today’s markets and fears that a correction in equity, and some credit markets such as high yield, is just around the corner.
“The downside of the “melt up” in equity markets is that this in itself has created worries about investor complacency, and that it will only be a matter of time until we are presented with a market correction. Although as John Templeton said, bull markets “mature on optimism and die on euphoria” and it would be difficult to find anyone who truly feels euphoric about markets right now,” Craig said.
Adding that mean reversion would suggest the VIX should rise, Craig argued that long periods of low volatility and are not unheard of, pointing out: “The VIX was at low levels during the mid-1990s and mid-2000s, when US markets were in bullish territory. It may make sense to point to the S&P 500 hitting multi-year highs and say that volatility should be low, but this doesn’t feel right given the events of the past few years, or even since the start of this year.”
Ways to play the sense of disquiet
According to Andy Cawker, head of specialist equities at Insight Investment, while the IPO machine continues to fire on all cylinders and M&A is back: “secondary market activity is subdued, which suggests many fund managers are uncertain about the melt up in markets and unwilling to commit to large active positions”.
He adds: “We are similarly cautious. We are reducing our exposure to stocks and sectors that are sensitive to the Uk consumer. Household indebtedness remains high in the Uk.”
Bestinvest’s Jason Holland is also concerned about the low levels of volatility. He argued recently that with markets high and a lack of compelling valuations in most asset classes, caution is warranted; suggesting that now could be the time absolute return funds deserve to be on the radar again.
To this point he suggests, multi-strategy absolute return funds, long/short funds and multi-asset funds with a low volatility approach could be worth looking at.
