The great volatility debate

The great volatility debate

Timothy McCourt and Matthew Tagliani, executive directors, equity products, CME Group 

Despite a recent flurry of activity in certain asset classes, volatility has not returned to financial markets in any meaningful way and may not return so long as global central banks continue to provide markets with excess liquidity and remain fully committed to providing substantial assistance should any financial institution get into trouble. The resilience of the market to the normal sources of volatility is demonstrated by the contrast between the significance of recent geopolitical events with the insignificance of the market’s reaction to them. In 2014, we have witnessed the Russian annexation of Crimea, the shooting down of a civilian passenger plane over Ukraine, aggressive economic sanctions against Russia by both the US and EU, fresh instability in Iraq prompting new deployment of US troops and the most violent conflict in Gaza in a decade.

And how have markets reacted?  Equity markets are modestly higher, crude oil remains flat, 10y US Treasury yields are down slightly and gold has rallied.  Both realized and forward-looking implied volatility, after hitting decade lows in early summer, have ticked up only slightly and remain very low by any historic measure.

Global financial markets are interconnected and while central banks continue to intervene in two of the largest asset classes – interest rates and currencies – there is little likelihood for the return of significant volatility to any asset class in the near term.  The next foreseeable catalyst will be when (and if) major central banks such as the Federal Reserve or the Bank of England, step back from their emergency policies of near-zero short-term rates.  As economic growth prospects diverge between the US and UK on the one hand, and continental Europe and Japan on the other, the likelihood of a meaningful rise in volatility increases.

Russell Rhodes, senior instructor, CBOE Options Institute

It’s been well publicized that this year the level of the CBOE Volatility Index (VIX), the most-cited measure of expected volatility, has been low relative to levels in the post-2008 financial crisis. As of early August, the average VIX closing price was 13.65, the lowest average since 2005 when the close averaged 12.81.  It would be incorrect, however, to assume that VIX’s recent low level automatically equates to low market volatility across the board, as there have been pockets of volatility in market sectors that have experienced higher implied volatility in 2014 than in 2013.

The measure of volatility for small-cap stocks in the US, represented by the CBOE Russell 2000 Index (RUT) – is one area in which there have been excessive volatility levels relative to history. The Brazilian market is another index displaying increased volatility expectations in 2014.  However until the national elections pass, it is likely that volatility as indicated by option pricing will remain elevated for the Brazilian market.  

Finally, it is worth mentioning that implied volatility is a mean-reverting measure, and VIX levels have been lower than the long-term average for well over a year.  In time, VIX undoubtedly will revert to a higher level for several possible reasons. Some market watchers think we are overdue for a market correction, others view the September-October period that is almost upon us as being historically treacherous, while others believe that we could experience another geopolitical flare up - one that lasts more than two days.  The question is not if something will happen that pushes VIX higher, but when will it happen.

Vicky Sanders, Head of Analytics Sales, Marex Spectron

“Double, double toil and trouble; fire burn and caldron bubble.” We find ourselves not in a cave but four years into a volatility bear market and while it won’t be eye of newt or toe of frog, there must be something to stir some drama in the derivatives market. For volatility to rise, either expectations of future price movements must change or demand for it must increase. The question is obviously what can cause either to happen?

The reasons for the post-crisis collapse in implied volatility curves are known to most: zero interest rates, range bound markets, reduced risk appetites, fewer macro-economic surprises, and exhausted demand for tail risk structures. The average one year realised volatility for a group of ten benchmark commodities peaked at the 95th percentile at the end of 2009. It has fallen steadily since, currently hovering just above the 15th percentile. That is well below where we entered the financial crisis when volatility sat nicely at the 50th percentile.

In markets that range, flat price positions are eschewed in favour of spread and relative value trades. At the same time, with lower volatility, VAR-driven position limits mathematically rise. Lulled into a sense of calm, sizes of positions slowly expand while perceived risk falls, creating a set up for a rather painful unwind. The brutal collapse of the August-September Brent spread is a prime, and recent, example.

As ever in financial markets, timing is key. So why now? In this cycle we have never been closer to a change in monetary policy. Positions have grown and prices have begun to move – various commodities have broken out of ranges after events such as the Indonesian ore ban, Artic vortex, and Brazilian drought. Brent & WTI flat prices have broken lower on the multiple bubbling geopolitical risk areas – Gaza, Ukraine and Iraq. Volatility in other asset classes has begun to rally. GBP/USD 1month implied volatility is having the largest summer rally since 2008. As currencies are directly linked to interest rate expectations, they may likely be the first to move in a broader cross-asset resurgence in volatility.

Owain Johnson, chief of products and services, Dubai Mercantile Exchange

This summer saw the Middle East and Asian crude oil markets awaken to renewed volatility after an unusually extended period of price stability was brought to a dramatic end by geopolitical concerns in Iraq and Russia. After a first half characterized by price stability and a lack of general trends to follow, the summer months have seen a return to the volatility that had been the hallmark of the crude oil markets in recent years.

The major driver of regional volatility was and continues to be the uncertain situation in Iraq.  The initial campaign by Iraqi insurgents in mid-June pushed DME’s Oman crude oil futures contract to trade above $110bn for the first time since the previous September.

The lower price levels came amid greater confidence that Iraqi insurgents were not targeting the key southern oil-fields and followed a reduced demand forecast from the International Energy Agency, which cited weaker-than-expected second-quarter economic growth in developed countries and a drop in oil stockpiling in China.

The regional oil markets continue to feel very tense – weak refining margins and a surplus of crude would normally lead to lower prices, but relatively few market participants feel comfortable in taking a large short position when geopolitical risk surrounding two major producers like Iraq and Russia remains so high.

The key question now is whether this summer saw the return of a new period of greater volatility.  Much will depend on how events in Iraq unfold.  The difficult situation there has caused much work on new oil fields to cease, thereby reducing Iraq’s medium-term production prospects.  This lack of increased supply from Iraq could well generate greater price movement in the future as demand increases once more.  As well as generating short-term volatility, the impact of the situation in Iraq is likely to be felt in the market for years to come.