Market Memo: Don't fear the low 'fear indexes'

05-16-2017

Volatility has been very low in recent months across multiple assets classes, including stocks, bonds and currencies. Many investors have been surprised at the complacency in the markets given geopolitical risks (North Korea, for example), domestic political risks (tax reform, trade war, etc.) and central banks in the U.S., Europe and China either removing, or talking about removing, monetary-policy accommodation. 

The MOVE Index tracks the volatility of Treasury bonds. One reason it is at 3-year lows is because interest rates have been stuck in a tight range since December. Rates have been unable to move up much due to buying from yield-starved overseas investors and uncertainty on the prospects for passage of Trump’s pro-growth policies. At the same time, however, rates have been unable to move down much due to firming global growth and gradually rising wages. Additionally, while the Fed continues to inch up the federal funds rate, its moves have been gradual and well telegraphed, adding to the calm in the markets. 

Bond traders also keep an eye on the VIX, a measure of stock-market volatility, since it has historically been highly correlated to the performance of stocks: rising when stocks sell off and falling when stocks rally. Since corporate bond spreads—particularly lower-rated high-yield credits—are correlated to stock-market returns, a large increase in the VIX often correlates to corporate bond underperformance. The VIX is currently near all-time lows as the S&P 500 flirts with all-time highs. One reason stocks continue to head higher may be the market’s faith in a Fed “put,” or the expectation that any significant correction in the stock market will cause the Fed to delay rate hikes and balance-sheet contraction.

While it’s tempting to buy volatility at these low levels, history shows that in the absence of a catalyst, volatility can stay low for extended periods. Because a long-volatility strategy, such as buying option straddles that gain whether a security's price rises or falls, is a negative carry trade, something must happen to cause volatility to spike for the trade to be profitable. But because this “something” is by definition a surprise, it’s very difficult to correctly time.