Low volatility favours ‘hunt for yield’ but warning from IMF
|Implied or traded volatility has continued to fall this autumn. VIX (equity) volatility fell close to a record low in October. The same pattern is seen in rates volatility, with 3M10Y swaption volatility falling to a level not seen since 2015 in USD and close to, or at, the lowest level in EUR since the introduction of the euro.
Low yields and low volatility add to leverage and ‘hunt for yield’
The predictability of global central banks – that given low global inflation pressure they are eager not to tighten too fast – is one reason for both the low realised and implied volatility. The ECB plans to continue QE for another nine months and has soft forward guidance; the centrist Jerome Powell has been appointed to succeed Janet Yellen and in Japan the yield-control policy is firmly in place – all examples of central bank policies that have enhanced the perception of central bank predictability.
The macroeconomic stability that has emerged over the past couple of years has also added to the low volatility regime. There are simply too few hot spots in the global economy to concern investors about at present. Catalonia, North Korea and Donald Trump are no longer able to derail investor optimism.
When volatility is low it is more attractive, or some might even say tempting, to increase leverage. The different risk measures, such as VaR, depend on historical volatility. In particular, when yields are low or even negative, it is almost a necessity to use leverage to achieve a ‘decent’ return or carry . We often call this ‘hunt for yield and carry’ behaviour. When investors are hunting ‘y ield’ or ‘carry ’, they themselves add to the low volatility environment, as even the slightest mispricing or adverse market move is quickly reversed.
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