How volatility eats itself Part 2

The rise in FX volatility is already feeding into higher equity market vol, as discussed here. That post came out where the red line appears on this updated chart:
VolThe missing part of the puzzle has been bond markets, which have been relatively well behaved (the white line on the chart). That may not continue with the US 10yr sitting on 2.35%, the lows of the recent range:

US 10yr 8 Oct 2014. Tonight’s FOMC Minutes are widely expected to be hawkish, as they have proven to be for most of this year, given the make-up of the whole board is more hawkish than its subsidiary parts. Hence the significant increase in the median “dot” over the course of this year. However, markets move to price in new information, and we run the risk of “Buy the rumour, sell the fact” as everyone is expecting hawkishness already.

This isn’t just important for fixed income traders. Since the financial crisis, there has been a heightened awareness of how markets interact, and how a signal from one market can suggest that positions in another should be covered.

When markets watch one another, this can cause volatility to propagate. Take a look at this latest research piece from the Federal Reserve Bank of New York. They are trying to deduce ‘what can we learn from prior periods of low volatility’ but the most important chart is this one:
NY Fed Vol

This says: Volatility is low because Treasury yields are low and not moving around very much. It’s very different to Lehman, when household confidence was in disarray, credit spreads were high and random news was flying around.

You may discount this as telling you what you already know. The authors themselves conclude:

During times of relative market calm, like today, it could be that low financial market volatility is pushing these fundamental drivers lower, rather than the other way around.’

But the ongoing conclusion from that is dynamite. If low volatility is caused by low rates which in turn cause low volatility, what happens when rates go up? Even worse, what are these alleged indicators of volatility telling us? Precisely nothing. You can no longer place your portfolio in risky assets, sit back, and wait for an exogenous factor to tell you when to hedge. There are no exogenous factors. Volatility is eating itself, and when the market realises, we will be in for one hell of a panic.

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