The Blog

Why Are the Markets So Quiet?

Implied volatility, as traded in the vast global FX market, has collapsed to levels not seen since 2007-just before the collapse of the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund which, (if we had but known it), fired the starting gun for the great financial crisis, (GFC). The Deutsche Bank FX Volatility index of 3-month volatility for nine major currency pairs stands at 6.17% as I write, against a low for the last 10 years of 5.51% on 10th July 2007 and a high of 24.24% on 27th October 2008. One could make almost exactly analogous observations for the famous VIX Index of equity market volatility, and also in many other major markets, including fixed income and gold.

Speaking at the Deutsche Bank Global Financial Services Conference, JPM's Investment Bank CEO, Daniel Pinto, highlighted that investors have incurred widespread losses this year because two trades which were hugely consensus have not paid off - long USDJPY and short US Treasuries.

Bloomberg quotes Pinto as saying "Neither of those trades paid", "Essentially you start the year with the wrong momentum, where you lose money at the very beginning, and you ended up with probably a lower risk appetite than you would have otherwise."

The Newedge Macro Trading Index of discretionary hedge fund performance stood at -3.06%, YTD, as at 30th April.

So what's going on, (or rather not going on)? Is the world really back to a state of 'Great Moderation', as enjoyed in the first half of the noughties, once the dust had settled after the dot com boom and bust? As ever, the answer is probably not simple, but rather a confluence of several drivers. It is undoubtedly the case that major central bankers have got smarter or luckier and currently have the markets in their thrall. From Draghi's 'whatever it takes' promise, to the belief that there will always be a Fed Chair 'put' in place, through a perennially dovish Mark Carney at the Bank of England, to an uncharacteristically dovish Bank of Japan Governor, Kuroda, and a Chinese administration that apparently always has its finger on the trigger, ready to ease if growth drops below target or a property crash looms, the stars are aligned in a constellation that assures investors they should not fret; if things turn ugly then monetary policy will ride to the rescue.

The only problem is that there are finite limits to the efficacy of monetary policy; a law of diminishing returns beyond which no amount of easing can undo the harm done by failure to implement structural reform to, for instance, labour markets, or failure to address long term fiscal profligacy. Then there is also the concern over the unknown long-term consequences of the QE 'infinite' experiment; even now there are some saner voices at the Fed who have begun to worry about market mis-pricing of risk, e.g. in the junk bond market.

There are reasons for thinking things may be different this time; banks supposedly no longer sport evil proprietary trading desks playing the 'trader's option', we are supposedly wiser and less greedy; securitization of toxicity is a thing of the past, we place less blind faith in credit ratings, we understand the limitations of VAR, and we see lamentations of Black Swans flying over every tree top, so we all have a propensity to be long of volatility, due to the psychological damage inflicted by the G.F.C, which in turn means that delta hedgers are always looking to fade any large moves to pay for premium. The Euro is safe thanks to Merkel and Draghi. Oh, and surely 14,000 pages of Dodd- Frank regulations mean we can all sleep soundly in our beds?

If you believe all that,'ve learnt nothing.

The phrase, 'things may be different this time' should always set off alarm bells, and the complacency we are witnessing today is horribly reminiscent of the low vol. environments of 1996, just before the Asian Crisis, late 1999, just before dot com bust, and 2007, just before the G.F.C. Whilst low volatility is not of course by itself a leading indicator for crisis, (unless you believe it is a proxy for excessive leverage), certainly post facto it seems to be a good warning sign that one should be out of risky assets, carry trades, and leverage-in fact anything that assumes all is just fine and dandy; like 10yr Greece at 6%.