Where’s the (implied) volatility?
There is a new American president with an economic agenda that is long on radical ideas and short on specifics. We have just endured the first major inflationary incident in decades — and it may not be over yet. Stocks are at extremely high valuations and long-term bonds yields are in flux. Federal Reserve monetary policy rests on a razor’s edge. Uncertainty, in sum, appears to be everywhere. Why, then, are indices of implied — that is expected — stock and bond volatility so low?
The Vix index, the options-implied movement of the S&P 500, moved down yesterday, and at 15 it is below the threshold usually taken as a sign of market fear. The Move, the equivalent index for Treasury yields, is trading in its usual band. The implied volatility of investment-grade credit spreads is near a multiyear low, too.
These indices are based on the prices investors are paying for portfolio insurance, in the form of put and call options. Shouldn’t insurance be expensive right now? One explanation is that there is too much policy uncertainty. As a result, there is not much speculation in the options market, which suppresses volatility indices. From Russell Rhoads, head of research at EQDerivatives:
Most professional traders seem to be in a wait-and-see mode. Wait-and-see implies they are not putting new hedges and not speculating too much, as they don’t know what is coming around the bend . . . For the Vix to be active, you need a lot of activity in the index options.
The same logic applies to the Move. Traders still don’t know how to price Donald Trump’s unique mix of populist and conservative policy promises. The market, perhaps, is like a deer in the headlights.
Another possibility: there was a mechanical flow-through from good recent earnings and economic results to lower implied volatility. Fourth-quarter earnings results have been strong so far, causing a rally for those who have reported, but not for those who haven’t. Last week’s inflation print was not as dire as many predicted. According to Garrett DeSimone at OptionMetrics, those both “translate to lower market volatility”: diverging equity performace lowers correlation, in turn lowering the Vix, and the fall in inflation expectations pulls down bond yields, “which would be supportive of both a lower Vix and a lower Move”.
That does not mean that there is no volatility in markets. Trump’s tariff threats have appeared, logically enough, in currency markets. Rates svengali Ed Al-Hussainy at Columbia Threadneedle notes that:
Markets have focused on foreign exchange as the key adjustment mechanism in response to tariffs (higher tariffs = stronger dollar). The rest of the policy mix — immigration/taxes/regulation/etc — is too amorphous to price. This leaves a lot of room for last year’s positive economic/earnings growth story to continue driving risk higher.
At some point, policy proposals will turn into policies, for good or ill. Until then, the usual “fear gauges” might not tell you much.