The Macro Minute

How vol eats itself

We are all aware of how volatility – in all assets – is at historically low levels. Some people shrug and say it’s just a function of endless central bank liquidity, and hey doesn’t something called the World Cup start today? Those who worry about it are dismissed as sadomasochistic Cassandras, waiting for the day they can say “I told you so….”. But what if it’s telling us something about the structure of the market?

 

The big macro story continues to be the question of when the G4 central banks will tighten. A congregation and then capitulation of positions has led to a crisis of confidence – see here for more http://blondemoney.co.uk/?p=376 – but now regulation is exacerbating the issue. Market makers can’t hold onto positions as risk levels are cut. Long-term investors must find and hold onto yield. Speculators are running into, and then falling over, each other as they look for where trends might occur. This has left the market becalmed.

 

Low volatility doesn’t necessarily mean that nothing much is expected to happen; rather, that no-one dare expect something might just happen. Conviction has been crushed.

 

Look at the price action in options after two recent big macro events:

 

1. ECB delivers a stimulus package – EUR/USD 1month vol reverses from almost the year’s highs, to the year’s lows in the space of 2 trading days  EURUSD 1m vol

2. The RBNZ delivers a 25bp hike and signals they’d like tighter conditions ahead – NZD/USD 1month vol drops to the lowest level in almost 20 years
NZDUSD 1m vol

 

Now, it’s normal for vol to drop after a big central bank decision. Event risk uncertainty disappears and we have new data to play with. But these kinds of reversals show just how nervous the market is. It would rather not even hold volatility, because even that could turn out to be worthless.

 

Effectively, vol is eating itself. Expectations for next week’s Fed meeting are subsequently very low, even as the central bankers themselves have flagged up their concerns. Note Hilsenrath’s article last week: “Fed officials are starting to wonder whether a tranquility that has descended on financial markets is a sign that investors have become unafraid of the type of risk that could lead to bubbles and volatility” http://on.wsj.com/1iqaFuU

 

Is it a sign of no fear? Or is it fear of risk itself?