Why another volatility explosion could be on its way

In all of the market predictions for 2019 being rolled out by banks and asset managers, few appear to address the threat of another volatility surge and the attendant risks to world markets.

But according to some global markets experts, that growing risk is very real.

Erik Norland, senior economist at the derivatives exchange operator CME Group, in conversation with AsianInvestor in December, said there is a historical cycle of volatility that is on course to repeat again but market indicators don’t recognise it.

In assessing the various macroeconomic scenarios for this year, he said the “most fascinating” aspect of his current macro analysis is that “nobody cares about risk”.

“We’ve seen this sharp sell-off in the stock market and yet the cost of options has not increased very much," London-based Norland said while on a trip to Hong Kong.

The CBOE Volatility (Vix) index, which is calculated by the rival-run Chicago Board Options Exchange (CBOE), is widely used as a barometer for market uncertainty. It assesses the expected volatility over 30 days of the broad US stock market, as represented by the S&P 500 index.

Despite a brief spike last February and, more recently, just before Christmas, it has generally stayed below its historical average since the 2008 global financial crisis.

“The Vix has gone up to only 20% implied volatility, which isn’t very high,” Norland said. “But it’s not low only on the Vix; this is [also] the case with most of our markets such as options on agricultural goods, metals, bonds and currencies.”

His analysis suggests trouble is brewing, especially if US monetary policy tightening is implemented too aggressively.

With the Federal Reserve still set on raising short-term interest rates, as it did for the ninth straight time on December 19, the US yield curve has been flattening as inflation expectations ease, pushing down long-term yields. So while the Fed funds rate has a current band of 2.25%-2.5% and is projected to rise towards 3% next year, yields on benchmark 10-year US government bonds have come in from more than 3.2% in November to around 2.6% now.  

"When you have a flat yield curve but markets are generally quite calm like we have now, that’s often followed by an explosion in volatility. We’ve seen this cycle repeating over and over again," Norland said.

"The real risk here is that as central banks tighten at some point, maybe a year or so after the policy tightening ends, we see a tremendous increase in market volatility across every market."

IF IT INVERTS

In a market perspective note issued last week, Peter Yiu, director and private client advisor with Charles Schwab in Hong Kong, said: “If the Fed raises rates too quickly, causing short-term yields to rise above long-term yields, then the yield curve can invert. That’s when investors start worrying about a potential recession, as high rates slam the brakes on growth and inflation expectations."

He added that every recession in the United States -- and accompanying global economic recession over the past 50 years -- was preceded by an inverted yield curve.

Norland said he doesn’t know when this surge in volatility will occur, but it is coming.

“2019 could be a transitional year, with a move from the lower to the higher volatility state," he told AsianInvestor. "But I would expect [that] by the early 2020s we will be in a much more agitated state for all the commodity markets and all the financial markets."

“Investors who are used to seeing very calm, slow-moving markets, where they think a 2% move on any day is a big deal, are going to see a situation where that’s happening every day. That’s a bigger story than the 4% to 5% move in one day,” he said.

Philip Naylor, senior consultant with Frontier Advisors’ capital markets team told AsianInvestor the Melbourne-based firm has been anticipating an increase in volatility over the past year and is being careful in how it interprets recent central bank moves. 

"At this time of year, lower levels of liquidity can sometimes exacerbate moves – the recent ‘flash crash’ in the Australian Dollar is an example," he said.

As the process of tighter monetary conditions continues, Frontier expects there will be more episodes of higher volatility in capital markets.

"While equity option prices have risen, we don’t view them as expensive in light of the potential future volatility and, when viewed from a total portfolio perspective, equities still have a place in a diversified portfolio given relative valuations of other defensive levers such as bonds," he said.

Another market note issued by State Street Global Markets (SSGM) last week, while noting that the Fed has reduced its expectations for policy moves in 2019, from three to two likely moves, supports the view there is still more volatility to come.

“There was no announced change in (the Fed’s) plans for balance sheet reduction (quantitative tightening) and this is likely to mean more market volatility to come, despite the more benign rates message coming from the central bank,” Lee Ferridge, head of Multi-Asset Strategy at SSGM, said.