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Vince Foster: Implied Volatility Is Low Because Inflation Risk Is Low


One of the biggest contributors to volatility is inflation risk, which manifests itself in the value of the dollar, the yield curve, and credit and equity multiples.

The most hotly debated current market development is the persistent drop in implied volatility across asset classes. This year has seen implied volatility premiums drop to historic lows in equities, interest rates, and currency markets. This week I wanted to posit what could be causing multiple asset class implied volatility premiums to drop and what could cause it to rise.

On Friday the Wall Street Journal provided what is likely the consensus view as to why implied volatility premiums are so low. In VIX Volatility Index Falls to Lowest Level in Over a Year, the following was written:

Many traders say they detect little fear in the market lately. They cite a financial outlook that is widely perceived to pose little risk of an economic or market downturn: near-record stock prices, low interest rates, steady if unspectacular US growth and expansive if receding Federal Reserve support for the economy and financial markets.

Wall Street Journal VIX Vs. Periods of Fed Stimulus

The Wall Street Journal makes the commonly held argument that low volatility is the result of the Fed's expansionary monetary policy, which is removing fear in the market. This is a case where correlation is assumed to imply causation. The Fed has been injecting liquidity, and implied volatility is low, therefore the Fed's actions are driving volatility lower. I believe this is an erroneous assumption.

It's important to understand that implied volatility premiums embedded in options is not the same as realized volatility in underlying prices. In fact when investors are well positioned for volatility, i.e. long implied volatility, there is much less likelihood that volatility will occur. When everyone is hedged, the market won't move. It's quite possible that investors who entered the year anticipating increased volatility due to the Fed removing stimulus have been long and bleeding volatility premium.

This bout of low volatility premiums is unique in that it spans asset classes. It's not just equity volatility that is falling; it's also happening in rates and currencies. This phenomenon suggests it is systemic in nature.  Earlier this week Goldman Sachs (NYSE:GS) addressed this low volatility as potentially a justified function of the economic cycle:

So far this year, implied and realized volatility have fallen to low levels across a wide range of asset classes. This has brought increased focus on what to make of this, whether it is justified and how long it might last. Short bursts of volatility are often driven by events or market declines. But we have argued for a long time that the longer-term shifts in asset volatility are also heavily influenced by macro conditions. Those conditions include the state of the cycle and financial stress in particular, but also the level of overall macro volatility.
When I read this report I kept waiting on Goldman to corroborate my thesis on what is producing falling volatility premiums. It danced around it with a focus on the macro economic conditions but never pinpointed the specific reason.
I believe one of the biggest contributors to volatility is inflation risk. Inflation risk manifests itself in the value of the dollar, the yield curve, and credit and equity multiples. All else equal, when inflation risk is high, the dollar is weaker, the yield curve is steeper, and credit and equity multiples are wider. When inflation risk is low, the dollar is stronger, the yield curve is flatter, and credit and equity multiples are tighter.

Consider the 2008 financial crisis that is widely assumed to be a function of the collapse in the real estate market that started in 2006. But Lehman Brothers didn't fail because people stopped paying their mortgages; it failed because of a blowout in credit risk premiums. Credit risk premiums blew out when the yield curve steepened. The yield curve started steepening when the price of oil spiked. The price of oil spiked due to the weakening dollar. The dollar weakened when the Fed started slashing interest rates. By July the year-over-year increase in the PPI and CPI were 9.9% and 5.6% respectively. The spike in inflation caused the market to rapidly reprice inflation risk, and the massively leveraged system buckled under the pressure.
In 2011 we saw a similar spike in inflation as a result of the launch of QE 2. The short dollar-long real assets trade widely held, and at the time, I deemed it the reflation correlation. However this trade delivered a debilitating blow to the weak US consumer who was not able to absorb the increased costs. In July the year-over-year increase in the PPI and CPI were 7.1% and 3.6% respectively. In August the reflation correlation blew out and the stock market crashed.
When the Fed first floated the tapering of QE idea in 2013 the bond and currency markets responded in a similar manner. The dollar rallied and real interest rates pushed nominal interest rates higher, both discounting lower inflation risk premiums. Upon the initial adjustment rate and currency, implied volatility shot higher as the yield curve shifted back to positive real rates. With the Fed exiting, investors where positioning for a higher level of volatility.
FX Vs. Rate Implied Volatility Over VIX and Credit Risk Curve

Since the Fed actually commenced with tapering in January, equity, rates, and FX volatility have been falling. In addition the dollar has remained strong, the yield curve has flattened, and risk premiums have tightened. I believe the trifecta of volatility collapse is a function of a reduction in inflation risk due to the Fed exiting stimulus. It is a consistent move across asset classes and the respective prices for implied volatility. As inflation risk is reduced investors have more visibility for real returns and thus are willing to accept a higher multiple.
The deafening silence in market prices and implied volatility is due to falling inflation risk, and as the Fed continues to exit stimulus, there is no reason to believe that inflation could rear its ugly head. However this past week in one of the most important countertrends to the disinflationary bias was the participation at the 10-year TIPS auction. The auction stopped 2bps through the when-issued yield, was well bid, and indirect bidders -- which include foreign central banks -- took the highest allocation in history. As a result breakeven inflation rates embedded in TIPS yields rose to the highs of the year.
The bid for inflation protection from foreign investors is notable because of the currency implications. Does the bank of Japan foresee a stronger yen due to a reduction in stimulus? Are foreigners hedging what could be spiking food prices due to commodity prices? Maybe there is a sense that the Fed is going to back off their exit plans which reintroduces weak dollar inflation risk? It could be a combination or just a non-event coincidence.
Regardless of the reason the bottom line is while there seems to be no risk of inflation investors need to start paying attention to inflation risk. While implied volatility continues to drift lower it might be more helpful to monitor the term structure skew in currencies and rates. I can simulate both currency and rates term structure on Bloomberg via the difference between 1 month and 3 month implied volatility. When 1 month vol gets bid up relative to 3 month it can precede volatility in the underlying asset.
FX and Rate Implied Volatility Term Structure

Inflation risk is a major contributor to market volatility and the pervasively low implied volatility prices are a function of low inflation risk. From the demand side of inflation, it's hard to argue there is a threat because wage growth is so weak. As long as the Fed removes accommodation, excess liquidity that is responsible for higher inflation risk premiums will be reduced. From the supply side, however, commodity prices for food and energy represent the biggest threat to inflation.
The rising food prices are well known and should start to filter through consumer prices in the coming months. A spike in oil due to dollar weakness is also another threat. When rates volatility picked up last year it was preceded by currency volatility. I will be watching breakeven inflation risk and the term structure in JPY implied volatility. Were both to begin rising, it could portend a rise in inflation risk and an end to the low volatility environment.
Twitter: @exantefactor
No positions in stocks mentioned.
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