In a world where US political risk appears to be rising and nuclear threats with North Korea come amid persistent tensions in the Middle East and with Russia, worldwide market volatility appears to have blinders on. A Bank of America Merrill Lynch report out Wednesday, noting a “fearless VIX” dropping to 90-year lows, stands with mouth agape as it explains the market action. While low volatility could persist throughout the summer, the falling asleep of market volatility is not a “new normal,” the report predicted as Global volatility spreads home.
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Global Volatility – CBOE VIX Index Reaches “Historic Floor”
The CBOE VIX index, a measure of option trading activity used as a proxy to gauge market uncertainty or fear, traded below the 10 level on Monday.
This “historic floor” has only been hit nine times since 1990, the BofA Global Equity Derivatives research team noted. The report, titled “Global Equity Volatility Insights - US equity vol near 90yr lows; what’s driving it and how long can it last?” pointed to the historical marker: only 3% of the time volatility had been lower since 1928.
“Absent regional catalysts, global equity vol has fallen in sympathy and is among the most depressed components in our Global Financial Stress Indicator,” Benjamin Bowler and a team on the bank’s Global Equity Derivatives Research team wrote.
Global Volatility Different But Why Is US Volatility So Low?
Speculation that non-pulsed volatility is due to dealer hedging and heavy option selling, the report dives deeper in a search for causation. Bowler and his team think “healthy implied/realized spreads and low stock correlation” might indicate more is at play.
The historic low volatility might just be due to a combination of “the Trump rotation,” a unique set of circumstances brought on by hopes and “animal spirits” tied to the election, and market participants “conditioned to buy dips” are creating a market environment where volatility is subdued.
This muted volatility environment might not last, and those dip buyers might find they are playing with fire. “The potential for higher inflation which will push the Fed put strike lower, eventually ending the era of dip-buying as ‘free money’ even if growth surprises to the upside,” the report stated.
Global Volatility Across Diversified Markets Is Elevated
While volatility remains historically depressed, there is a divergence. Global cross-asset volatility remains well above long-term lows.
Looking at one market for volatility analysis typically doesn’t tell the full story.
BofA’s Global Financial Stress Index (GFSI), which follows 23 markets in global credit, equity, interest rates, currency, and commodities, looks for signs of market concern. While the GFSI is below normal at -0.15, it is well off its lifetime low of -0.66 hit during February 2006. The move is driven, in part, by global interest rates, whose volatility has been muted by central bank influenced low rates amid little expectation for a sudden shift in global interest rate policy.
When looking at European volatility, the report points to a dichotomy based on election math.
After the French election on April 24, global markets, including stocks, turned around and volatility evaporated after experiencing a significant build. But those very conditions that led to a volatility build pre-April 24 have now almost played out in reverse.
If Marine Le Pen were to win on May 7, considered an outlier result, it might lead to mean reversion of the same magnitude that took place April 24, only in reverse.
In Asia, volatility is low amid a “lack of demand for calls,” but skews – the implied volatility differential between out of the money, at the money and in the money options – remained elevated. “The low volatility and steep skew mean calls look cheap for stock replacement strategies or hedging upside,” the report said.