Why is volatility so low?

Market Realist

Overview: The last cheap asset class (Part 2 of 2)

(Continued from Part 1)

Why is volatility (VXX) so low? The simple answer is that financial market volatility is mostly driven by the credit cycle. When monetary conditions are loose – meaning credit is both available and cheap – market volatility tends to be lower. This relationship is evident when you compare equity market volatility with a proxy for credit market conditions, such as high yield spreads. In the past, the correlation between high yield spreads and equity market volatility has been roughly 80%.

Today, short-term interest rates are still stuck at zero, real short-term rates are negative and companies are flush with cash. In other words, credit conditions are about as easy as they get, a fact reflected in very tight high yield (HYG) spreads, currently at a 7-year low of around 325 basis points. With credit conditions this easy, you would expect a low volatility regime.

Market Realist – The previous chart shows the spread of the Barclays High Yield Index (JNK) to ten-year Treasuries (or IEF). This is a different index than the one Russ quotes above, but serves to illustrate how tight credit spreads are relative to history. The credit spread represents the premium that investors want to get paid over what a risk free security like a U.S. Treasury pays. Usually when the economy starts to recover, credit spreads contract as credit default risk lowers and investors are willing to accept a lower premium.  However, in the current scenario, due to quantitative easing, spreads are likely as tight as they can get. Even if the economy recovers, the upside for corporate bonds (BND) from further spread compression is minimal. Actually, there’s more downside from interest rates rising faster than expecting and hurting bond prices.

That said, I believe there is a big difference between where volatility should be and where it is today. Even after adjusting for unusually tight credit spreads, volatility should be in the mid-teens, not scraping close to single digits. At today’s levels, volatility is in the bottom 1% of volatility levels going back to 1990. In other words, volatility looks too low even after accounting for a very benign credit environment. This is particularly true considering that investors are ignoring rising geopolitical risk, including recent events in Iraq that have the potential to lead to a nasty spike in oil prices.

The bottom line for investors is that in a world of few bargains, volatility does appear to be the one relatively cheap asset class. And while a continuation of zero interest rates and cash-flush companies will most likely keep volatility below its long-term average for the foreseeable future, it will take a lot of good luck to keep volatility as low as it currently is. This suggests that investors looking to potentially help protect portfolio performance if market volatility suddenly rises in the case of an unexpected correction may want to consider buying volatility.

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