Strange Brew: Heightened Uncertainties, Yet Plunging Volatility…What Gives?

Key Points

  • Volatility has been plumbing historical depths, but it may not be reflecting investor complacency.
  • Exchange traded products deserve some of the "credit" for low volatility.
  • The Fed's plans for its balance sheet, more than rate hikes, could bring on spikes in volatility.

Much ink has been spilled lately by the financial press on the dramatic move down in market volatility as measured by the CBOE Volatility Index (VIX), to the lowest level since February 2007, as seen in the chart below.

Volatility Index (VIX)

Source: FactSet, as of May 5, 2017.

The extremely low level of volatility seems odd when in contrast to geopolitical anxieties, North Korea's saber rattling and U.S. fiscal policy machinations, among other uncertainties. Low volatility is often viewed as a sign of complacency and/or the calm before the storm. Indeed, there have been times when storms followed periods of suppressed volatility; but what may surprise folks is that larger-than-normal price moves can happen both on the upside and downside.

Looking at various time periods subsequent to historic dips into single-digit territory by the VIX, you can see that the stock market's performance was choppy—albeit positive in median terms—in the subsequent months; i.e., not indicative of a market top.

Volatility index table

Source: Bespoke Investment Group (B.I.G.), Bloomberg, as of May 5, 2017.

Give credit to ETPs?

But there are some more nuanced reasons than complacency for today's suppressed volatility. Many traders are now suggesting that exchange-traded products (ETPs) linked to the VIX index have had a hand in the perceived distortion, according to Bloomberg (although it's difficult to prove that ETPs apply consistent pressure which pushes the VIX down). VIX ETPs have attracted over $700 million this year; which could exacerbate a selloff if volatility spikes.

In addition, investors may be relying less on S&P 500 index options for protective insurance on their portfolios. According to Bloomberg, investors are instead using alternative ways to manage risk in their holdings, such as options strategies that generate income as well as options on U.S. government bonds.

From QE to QT

Another relationship worth noting is between volatility and the Federal Reserve's balance sheet. Since the eruption of the financial crisis, the Fed's balance sheet has ballooned to $4.5 trillion; during which time volatility has retreated markedly.

But as you can see in the chart below, each time the Fed stopped quantitative easing (QE)—i.e., stopped adding assets to its balance sheet—volatility spiked. Although volatility has remained fairly suppressed since the Fed ended QE, it's likely that the somewhat imminent shrinking of the Fed's balance sheet ("quantitative tightening," or QT) could lead to some spikes in volatility.

VIX versus FED Balance SHeet

Source: Bloomberg, as of May 5, 2017.

Prior to the third and final round of QE, there was about a two-year lag between changes in the fed funds rate and changes in equity volatility, according to Bloomberg. More recently, the level of volatility has been driven more by the size of the Fed's balance sheet than by the overnight fed funds rate.

In sum

Volatility is suppressed, but it will return at some point, so be mindful of not getting lulled into a false sense of comfort. With fresh stock market highs having been reached, now may be a good time to assess whether some portfolio rebalancing is in order, for the benefit of keeping allocations in line with your risk tolerance-based targets.

 

Next Steps

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