A nervous peace prevails in the financial markets as central banks sit on their throne, fingers at the ready on the liquidity switch. As UBS' Bhanu Baweja notes, most volatility buyers have been 'rolled' into their graves. As they have explicitly targeted risk premia in addition to rates, a lot more hangs on the monarchs of monetary policy today than it has in previous cycles. While growth and inflation are both low, they are not necessarily uncertain; and although every crisis is different, certain patterns tend to repeat and certain events have reliably driven volatility higher.
What has driven VIX higher in the past
Valuation bubbles popping: the Great Depression was by far the largest volatility event of the last century and although the causes of the depression are controversial the asset valuation bubble and the stock market crash that followed are not. More recently we have seen the dot com bubble and sub-prime crisis bubble cause much smaller volatility spikes. While we can't say with any conviction that any market is already in bubble state, we are watching the high yield credit market and China property market most closely.
Fed surprise rate hike: in February 1994 the Fed raised rates from 3% to 3.25%, the first hike for five years. The effect on markets and volatility was actually larger for the second hike to 3.5% in March. The S&P 500 fell 10% and VIX rose from 9.9% to 23.9%. VIX rose again in June 2004 when Greenspan hiked from a much lower starting level of 1% increasing the Fed funds rate by 2 percentage points per year until he handed the reins to Bernanke. We think that US wage inflation surprises may well lead the Fed to hike sooner and faster than markets expect and this would end the low-volatility regime.
Middle East War and Oil: following the Yom Kippur war in 1973 Arab states reduced production and increased the price of oil by 17% and announced an embargo on oil exports to the United States. The spike in oil price drove down US share prices and drove volatility higher. Although oil futures positioning is at a record high we do not expect current events in Iraq will cause an oil spike.
Politicians: although the track record for reducing volatility is poor for politicians their ability to increase volatility is considerably better. These could be classified as the three D's: disease (Eisenhower's heart attack in 1955), death (Kennedy's assassination in 1963) and dishonour (Nixon's departure after Watergate in 1974). Unfortunately the three D's are not predictable.
Flash crashes: in 1962, long before the existence of programme trading, algorithmic trading, dark pools or "Flash Boys" there was a severe and inexplicable one-day market crash. This happened on May 28th and quadrupled realized S&P 500 volatility from 10% to 40% with a one-day Dow Jones fall of 5.7% and S&P 500 fall of 6.7%. The SEC tried to find the cause of the crash but could not. A similar event occurred on Black Wednesday in October 19, 1987 and again on May 6th 2010, although this was less severe. Flash crashes are inherently unpredictable.
* * *
So it seems we are potentially 5 for 5... good reason to BTFATH!!?
But low volatility can last (and has lasted) a long time...
chart shows the average time it takes, in days, for VIX to revert to
its long-term average of 20.1% given the value of VIX today