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Financial Times op-ed – Low volatility shows investors are underpricing risk

May 29, 2024

This op-ed first appeared in the Financial Times on 29th May.

Are financial markets pricing sufficiently for future risks? Measures of financial market volatility suggest not.

There are different measures of market volatility. Occasionally, they move the same way. This is often countercyclical, when the economic environment is stable and the political and policy outlook is clear and predictable.

Shocks, likewise, can have a similar effect, usually triggering rising volatility. Then the policy response may lead asset classes to behave differently, both in direction and volatility.

What about now? Volatility across equity and currency markets is low. The most widely followed gauge of equity market volatility expectations is the Vix. Its value of 12.46 compares with an average over five years of 21.5 and over the longer-term of 19.9.

Increased issuance of yield-enhancing structured investment products and their greater use by option dealers has reinforced the low value of the Vix. Notwithstanding this, other measures such as standard deviations in market moves confirm low volatility. The fall in inflation since 2022 has been the main driver. Equity markets, it seems, are discounting good news and a disinflationary environment.

More remarkable, perhaps, is low volatility across currency markets. The DB index of foreign exchange volatility captures the picture. It is at 6.3 versus an average of 7.6 over five years and 9.3 over the longer term. This is despite bouts of volatility associated with a competitive weakening of the yen, renminbi and won. 

However, low currency volatility may discourage hedging, undermine market depth and resilience. Low volatility and tight spreads in credit interest rates over benchmarks have also been evident in corporate bond markets, despite higher refinancing costs and defaults. 

In contrast, volatility in bond markets has risen this year. The ICE BofA Move index of volatility in US Treasuries is at 83.6, just below both its five-year and longer-term averages. This is explained by the market’s shift away from expectations of a large number of rate cuts in the US. 

As policy rates fall, bond market volatility should ease, perhaps temporarily. But the challenge is that many of the assumptions underpinning low volatility across markets may be subject to challenge. Not least is how the juncture of political, geopolitical, policy and economic risks are likely to align.

Take inflation. Inappropriate monetary policy and supply-side shocks led inflation to persist. A key driver of low global inflation over the past quarter of a century has been the combination of globalisation, technology, financialisation and a squeeze on how much of the national incomes goes to labour, or wage shares. Now globalisation is being replaced by fragmentation and in turn, wage shares have risen. The net result is monetary policy will have to work harder to achieve inflation targets. While policy rates can fall, they will settle at higher levels than pre-pandemic. Plus, there is uncertainty about where neutral rates, where monetary policy is not too tight or too easy, lie.

Fragmentation still has some way to go. One area to watch is digital currencies. If the imminent low-scale rollout of mBridge, a project involving China, Hong Kong, Thailand and the UAE, with more likely to join, is successful then it will not only reduce the costs of cross-border flows, but reinforce a shift in currency holdings. Passive dollar diversification will be a norm, as more central banks put less of their future reserves into the west. This will be disruptive. 

Markets are evolving from a focus on inflation to growth. A focus on debt will follow. While higher nominal GDP growth provides some temporary respite, debt levels, globally, are close to all-time highs. It is not only the level, but the future relationship between growth and rates that poses problems.

The plethora of elections this year has not destabilised markets as some feared. That’s largely because across emerging economies, incumbents have been re-elected or are likely to be. In Europe, the UK and US incumbents will suffer, as they did during the inflationary 1970s. That will trigger policy uncertainty and market volatility. 

Moreover, the geopolitical landscape is shifting to a less predictable G3 world, comprising the US, China plus the third group of middle ground powers, like India, Nigeria and Brazil.

It is hard to quantify fully political and geopolitical risks, but it suggests greater risk premia in many areas. It’s not just tail risks, but policy mistakes and economic vulnerability to possible shocks that could disrupt markets. It suggests the present calm may be replaced by increasing financial market volatility.