February Volatility - A glimpse into the future21/03/2018
Much has been discussed in the last month on the overall topic of volatility. Much of it by market commentators out of touch with the reality of micro market dynamics and the day-to-day business of trading options and volatility products. So what is the significance of the events of February in the VIX? Does it mark a change of regime? A return to higher volatility markets? Or something else altogether?
In truth markets are rarely so simple but perhaps there are some lessons to be learned from what has been a rocky start to the year.
Lesson 1: QE is not just about interest rates, it is about the suppression of risk premia.
Most traders know this instinctively, but it still bears repeating, QE was an implicit statement from central bankers around the world. As Mario Draghi said, "We will do whatever it takes". Turned out what it took was all time lows in rates, credit spreads and implied vols and, massive Central Bank balance sheets.
Chart shows decline in VIX vs growth in Fed Balance sheet.
Lesson 2: ZIRP chased people into dark corners they didn’t understand.
With the suppression of interest rates and the topping out of returns human nature always leads people to the next instrument of promise. Whilst short vol strategies, vol targeting, yield enhancement etc. all have their place and can be useful tools in a portfolio managers arsenal there is an importance to understand what you are trading. Volatility strategies and instruments are non-trivial. Way too many traders were involved in markets they didn’t understand and didn’t risk manage appropriately.
Lesson 3: Dodd-Frank got rid of risk-taking at banks. This increased certain risks.
One of the founding principles of Dodd-Frank was to reduce risk-taking by banks and in doing so to reduce systemic risk in financial markets. This was, however, an overly simplified viewpoint. Historically, at their best, banks have been a rationalising warehouse for risk in financial markets. Whilst high-frequency trading firms have taken over the reins of short term liquidity provision in markets, the depth of liquidity and smoothing of markets that banks offered has disappeared, particularly in derivative markets. The result has been increased risk of gaps as market counterparties shorten holding periods and rush to offload risk, subsequently pushing prices around in a way that would have previously been deemed irrational. It remains to be seen whether recent regulatory changes in the US will positively effect this situation, but with the growth of HFT and memories of the crisis still etched it seems unlikely to change soon.
Source: LENGTHENING THE INVESTMENT TIME HORIZON by Michael W. Roberge, CFA, Joseph C. Flaherty, Jr., Robert M. Almeida, Jr. and Andrew C. Boyd, MFS Canada
Lesson 4: Volatility is about uncertainty.
The last lesson is that we live in a world that is fundamentally more uncertain than at any time since the end of the cold war. Political consensus has broken down, institutions that were deemed untouchable are crumbling and a reality TV star is the President of America making pronouncements on trade via Twitter…
In such an environment markets are prone to gyration, and ultimately no matter how much you attempt to suppress that, free markets are going to respond to their environment.
Events of 5th February have pricked investors interests to risks they have either forgotten about or believed suppressed. For many there may be a temptation to draw the conclusion that this was a temporary blip in markets.
WE would argue that whilst the move in VIX on 5th February is an extreme example, it will not be the last example. A combination of normalising rates, more exotic products, reduced risk warehousing in markets and a fundamentally more uncertain environment mean that it is inevitable that these events will become more frequent. Buckle your seatbelts…
Author; Darius Tabatabai, Portfolio Manager at Arion Investment Management
Disclaimer: Although this document has been issued by Arion Investment Management, it is important to note that the views of the author(s) may or may not represent that of the company. The document has been derived from sources believed to be current and accurate as at the date of release. The comments made are general in nature and do not take into account anyone’s personal needs, financial situation or requirements and past performance is not an indicator of future returns. Before acting upon anything associated with this document we would recommend seeking advice from your financial advisor.
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About the company; Arion Investment Management Limited is a commodity focused investment management company, based in London. The company is authorised and regulated by the Financial Conduct Authority (registered no. 742037). Registered with the U.S. Commodity Futures Trading Commission (CFTC) as a Commodity Pool Operator and member of the National Futures Association (NFA).