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Curatia Analysis for Wed, Apr 17

The Volatility Paradox

For market participants, volatility’s long downward drift in 2019 offers a welcome respite from the traumatizing chaos of December.

Or does it? Rather than soothe investors, markets’ steady rise and abiding calm appears to be further unnerving them, prompting lower trading volumes, equity fund outflows, and an avalanche of prognostications of impending turmoil.

The trend highlights growing resignation to a new normal in which sharp volatility spikes punctuate long periods of market calm — a prophecy that threatens to become self-fulfilling as investors drain liquidity from markets in anticipation of the next volmageddon.

Market Conditions

Volatility is off 53% YTD, closing at 12.06 Friday to reach its lowest level in six months. The S&P 500, meanwhile, is within 0.8% of its all-time high after a 16% YTD surge. It has climbed in 13 of the last 16 weeks.

But far from touching off irrational exuberance, those trends have sparked an abundance of caution in investors. Equity trading volumes on NYSE and Nasdaq sank to 6.2B shares last week — their lowest level since August. Analysts have attributed the trepidation to “uncertainty about trade talks and a mixed economic backdrop.”

Bond and FX markets have also been eerily quiet. BAML’s MOVE Index, which gauges Treasuries volatility, is flirting with a record low, while currency volatility has been so subdued in the last six months that “traders have begun to wonder whether their pricing screens are broken,” with measures of expected rate swings hovering at five-year lows.

Doomsday Predictions

Despite trending calm and investor caution, industry participants are sounding the alarm that major turbulence lies ahead.

In his annual letter to shareholders, JPMorgan CEO and financial shogun Jamie Dimon said December’s market mayhem “might be a harbinger of things to come” owing partly to liquidity constraints. “‘Brace yourself for a choppy ride,’” Deutsche Bank Wealth Management Americas' chief investment officer Deepak Puri warned.

“An FX Volatility Explosion May Be Lurking Around the Corner,” cautioned a Monday Bloomberg headline. “How to Prepare for Inevitable Time When Volatility Explodes,” a Tuesday piece proffered while husbanding definite articles for the coming apocalypse.

Those prognostications highlight an emergent theory that seismic market structure shifts including banks’ retreat from liquidity provision, the rise of passive investing, low interest rates, and unprecedented levels of algorithmic trading have forged a new normal for markets: protracted periods of calm punctuated by periodic spikes in volatility.

Market ructions in February and December of 2018 appear to support that theory. The IMF’s latest Global Financial Stability Report warned that recent volatility spikes could be the “tip of the iceberg.”

Self-Fulfilling Prophecies?

Ironically, such warnings could themselves be a catalyst of volatility spikes. On Friday, Morgan Stanley cited “two big reasons low volatility will end:” high complacency and low liquidity.

Morgan Stanley cross-asset strategist Andrew “Spread” Sheets explained high complacency as “equat[ing] a Federal Reserve on hold with low volatility.” But that analysis overlooks two key points: a) volatility has closely tracked interest rates in recent years; and b) that knowledge does not translate to complacency unless investors engage in risk-taking as a result.

Instead, the opposite seems to be happening. Investors wary of low volatility are reluctant to jump into markets. US equity funds logged outflows of $39.1B in Q1 despite the S&P 500’s 14% gain during the period, puzzling analysts.

As those investors retreat, lower liquidity could exacerbate price swings, stoking volatility. Predictions of an impending volatility eruption garnering robust media coverage could thus amount to self-fulfilling prophecies.

The Ultimate Volatility Play

None of which is to say analysts warning of the potential for surging volatility are crying wolf. While interest rates have been the overriding factor in determining volatility, they are certainly not the only one. With volatility bound to surge eventually, such predictions carry no risk.

At the same time, bank trading revenues suffered mightily amid waning volatility in Q1. If warning of heightened volatility has the potential to conjure it into being, why not give it a shot?