A few thoughts on volatility

Market volatility is low, whether measured on an historical or option-implied basis.  Indeed, based on a measure of the normalized deviation of cross-asset implieds from long-term averages, it's the lowest since at least 2001 (the currency volatility index data only begins in that year).   Given the nature of asset markets in the 1970's-90's,  this essentially means that cross-market volatility is at its lowest level of the post-Bretton Woods era.

Now, you don't have to be a particularly discerning Fed-watcher to have realized that certain segments of the FOMC are getting a little antsy about the low levels of market volatility.  It's not quite at the level that they are shocked, SHOCKED to find that gambling is going on here....but it's not far off.

Indeed, the recent warnings from the Fed recall previous episodes of hand-wringing...notably Greenspan's (in)famous "irrational exuberance" speech in November 1996, as well as global monetary disquiet over the "complacency" and low levels of market vol a decade later.

Naturally, they would never admit to their own culpability, even though a cynic suffering macro punter anyone who sees better than Stevie Wonder realist might suggest that some of the culpability lays at their door.

Now, Macro Man will concede that it is somewhat tautological to use one measure of market volatility to explain other such measures.    However, the indicator that he likes to follow, the spread between the second and fourth eurodollar futures contracts, has historically been a pretty good proxy for Federal Reserve monetary policy expectations.  And as the nefarious Professor Woodford will tell you (or at least Ms. Yellen)...the FOMC can exert a great deal of power over market expectations of policy, and that these expectations themselves can have a substantial impact on markets (if not, as their voodoo might suggest, the real economy.)

In any case, if we look at the volatility of the 2/4 ED spread over the last quarter century, what do we find?  In late 1996, for example, the volatility of that spread was at its lowest point to date in the sample....just as Greenspan was moaning about irrational exuberance in the equity market.   Gee, Al, can you guess why equities were so perky?   

The last tightening cycle, of course, was incredibly well-telegraphed through the use of guidance-laden statements of the type we see still see today- "considerable period", "measured" withdrawal of accommodation, etc.   Greenspan, of course, famously credited the concurrent bond conundrum of low yields to his credibility and efficacious communications.   He must have been sleeping when those Asian central banks were buying hundreds of billions of dollars worth of Treasuries per year.....

In any event, the lack of volatility in expectations, which Greenspan triumphed in his self-fellating autobiography as a victory for transparent policy-making, naturally led to another massive misallocation capital and risk, most notably in the housing and volatility markets.  While the regulators have of course chosen to blame the cupidity of market participants (some of whom, it must be said, were truly loathsome), Macro Man cannot help but observe that they occurred simultaneously with a nadir in the volatility of Fed policy expectations.   The hangover, of course, required a little more than a few aspirin and a bacon sandwich to vanquish.

Fast forward to today, and we see that unsurprisingly, the measure of Fed expectations vol quite literally approached zero a couple of years ago, but has steadily risen since (though still remains at levels consistent with previous lows.)  Still, it's worth noting that the blow-ups generally seem to occur only after this measure eclipses 15 bps.    Russia/LTCM, the popping of the NASDAQ bubble, and the implosion of the Bear Stearns credit hedge funds in the summer of 2007 all occurred shortly after the 15 bps threshold was breached.

Perhaps it's a coincidence.  At the very least, there is no guarantee that the correlation implies causality- indeed, one could argue that some of the causality in the past may have worked in the opposite direction.

Nevertheless...in reference to the top chart of the post, Macro Man may not know when the next 2 SD move in cross market vol is going to come....but he has a damned good idea of which direction it's going to be in.  

With the FOMC and payrolls this week, it may be tempting to think that the rise in vol will come sooner rather than later.   Perhaps it will.   On Macro Man's read, however, we probably need to get a little closer to the whites of the eyes of the tightening cycle before vol buyers get the all-clear.