Volatility at the cusp of a resurgence?

Occasional spikes notwithstanding, volatility has been dormant across most asset classes over the past eight years. Equities, fixed income products, currencies, metals and agricultural goods saw steep declines in implied volatility after 2010, which has generally remained at exceptionally low levels for the past several years. However, we are beginning to see signs that implied volatility might be in the early stages of a transition that could take it to much higher levels across a range of products. 

Equity index options have been in the vanguard of this transition to higher volatility. S&P 500 volatility hit bottom in early 2018 and have since displayed a pattern of rising lows akin to 1996 and early 2007 as the market prepared to transition from low to high volatility. That said, implied volatility on S&P 500 options remains low currently by historical standards (Figure 1). 

In most other markets, volatility hit bottom more recently. That said, in fixed income, gold, silver and grain markets, volatility appears to be on the rise, although it remains at low levels. Periods of high and rising volatility usually have two things in common: 

1. A proximate cause: an event or series of events blamed for the rise in volatility. 

2. An underlying cause: the real reason why implied volatility shifts from low to high. 

The proximate cause varies from period to period. In the late 1980s, rising volatility was blamed on program trading in equities, portfolio insurance, and the savings and loan crisis. In the late 1990s, it was blamed on the Asian crisis, Russian debt default, Long Term Capital Management and later the “tech wreck”. The sub-prime crisis was blamed for the explosion in volatility in 2008. Without a doubt each of these diverse events contributed to rising volatility. Their common factor: monetary policy. In the years prior to these events, the Federal Reserve tightened policy and flattened the yield curve, making the economy more susceptible to credit defaults and setting the conditions for a spark to light the volatility fire. Each time the spark was different but each time a period of tight money eventually provided the tinder necessary to ignite a rise in volatility. 

When the Fed eases monetary conditions, money finds its way into markets. With abundant credit, buyers and sellers can transact easily and large orders can be executed with minimal price impact. Moreover, when low volatility environments persist, short-term volatility strategies prosper and investors become complacent. Quant models and traders can be beguiled by years of modest-sized market moves into underestimating the amount of risk. 

As the central bank tightens, it drains money out of the system. The problem is that after a period of tight money, there may eventually be fewer market participants who can take the other side of large orders close to the current price. Prices move, volatility rises. People get closed out of short volatility positions and the cost of options spikes higher. 

The interplay between volatility and monetary policy gives rise to a cycle that has been repeating in equity index options (Figures 2-4) for three decades. The cycle works as follows: 

1. Late Expansion: Tight money, characterised by a flat yield curve, gives way to a rise in market volatility. 

2. Recession: High volatility and weak economic growth oblige the central bank to ease policy, steepening the yield curve. 

3. Early Recovery: Easy monetary policy, characterised by a steep yield curve, generates a recovery. Volatility subsides. 

4. Mid-Expansion: Volatility falls to low levels and central bank tightens policy, flattening the yield curve.

In the current cycle, equity index volatility has been on a decided upturn since early 2018. Now bonds, gold, silver, copper and grain volatility, which has been following a similar cycle since at least 2007, is turning upward as well. 

Will the recent Fed cuts stave off a shift to higher volatility? We doubt it. After raising rates by 300 basis points in 1994, the Fed cut rates by 75 bps in 1995 and 75 more in 1998. Volatility trended higher anyway. Fed rate cuts in late 2007 and 2008 came too late to prevent a rise in volatility then too. As such, after raising rates nine times from 2015 to 2018 and shrinking its balance sheet, it might require much more than two cuts to quell a surge in volatility. 

Eric NORLAND Executive Director & Senior Economist - CME Group Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions. Prior to joining CME Group, Norland gained more than , 15 years of experience in the financial services industry working for investment banks and hedge funds both in the United States and in France. He most recently served in sales and research at BEAM Bayesian Efficient Asset Management LLC, and previously as Director of Research at EQA Partners, both global macro hedge funds. He also worked for IXIS Corporate & Investment Bank in Paris (now called Natixis), covering central banks and supranationals for the fixed income sales business, and also worked as a market economist and strategist. He began his career at Bankers Trust, Global Investment Management in New York working with the tactical asset allocation group. Norland holds a bachelor’s degree in economics and political science from St. Mary’s College of Maryland and an M.A.in statistics from Columbia University. He is also a CFA Charterholder.