Over the past year I have been lucky enough to have avoided the trap of playing for the “inevitable” VIX bounce.
VIX Index over the last 5 years</a> </div>
Although I would like to chalk my foresight up to a terrific market call, the truth is that I have been long volatility in other asset classes. My working thesis is that the next crisis will not look like the last one. Buying protection on the asset class that crashed last time will most likely not work as the trade it too obvious.
Instead of being long volatility in stock indexes, I have concentrated on being long fixed income volatility and foreign exchange volatility.
Unfortunately, these trades have performed no better than the long VIX trade.
Have a look at the long term chart of the VIX:
VIX Index</a> </div>
It is creeping along the lows. The past two years have been a steady dripping lower.
But what about bond volatility? What does it look like?
MOVE Index (bond volatility)</a> </div>
Bond volatility has also trended lower. In fact it might be performing even worse than VIX.
What about foreign exchange volatility? Let’s look at that.
JPM G7 Volatility Index</a> </div>
Although it is not yet at the lows like the VIX and MOVE indexes, it is also dragging close to the bottom.
I decided to create a home made index that combines these three different volatility measures. Here is the chart:
K-VOL Index</a> </div>
What is interesting is that during 1994 to 2002 this volatility index traded in a fairly predictable band. Even the LTCM (Long Term Capital Management) crisis was just a tiny blip outside this band.
Then during the aftermath of the DotCom bubble crash, volatility consistently trended lower. This collapse of volatility continued until 2007 when the sleeping lion roared awake.
The return of volatility did not simply push the index back into the previous range, but instead resulted in the largest volatility expansion we have experienced in many generations.
After experiencing a few wild years, recently the volatility has once again settled down.
But the truly amazing part is that instead of just settling back into the range we saw during 1994–2002, volatility has instead crept back down to new lows! Even lower than 2007!
I don’t think that many market participants would have ever guessed that we would see the shockingly low levels of volatility so quickly after the crisis.
When I try to reconcile this reality in my mind, I find myself flabbergasted about the mistakes we are again making.
I don’t buy for one second that the financial markets have become more stable and deserve to be at all time lows in terms of volatility. Instead, I believe that this recent push lower in volatility is the result of the same stupid mistake that the Federal Reserve made in the 2002–2007 period.
During the 2002 recovery the economy was suffering from a massive hangover from the DotCom bubble and the 9/11 attacks. Recognizing that the recovery was going to be fragile, Greenspan (and later Bernanke) soothed the market by promising to keep rates low for a considerable period of time. Their forward guidance created an impression of economic predictability. By doing so, the business cycle was not repealed, but merely delayed. It made the inevitable economic downturn all the worse. Since they had suppressed many self correcting market mechanisms, the economy was all the more unbalanced. The lack of volatility during the 2002–2007 had also encouraged too much speculation. Given that rates were held lower than they naturally wanted to go, there was a move out the risk curve by investors. Yet the lack of volatility was all an illusion about the true state of the economy. The Fed was able to keep it under control for a while, but eventually math wins out and the Emperor was revealed to have no clothes.
Surely the Fed would have learned its lesson. You would think so.
But in fact, the Federal Reserve has doubled down on the same policies. The Federal Reserve (and it is even worse this time because most Central Banks have now climbed aboard this same bandwagon) has once again embraced forward guidance. Again they are engaging in policies that create the illusion of stability. Again they are forcing investors out the risk curve. Again, they are suppressing volatility.
And let me ask you, do you think the economic situation has improved or deteriorated since 2007?
Have a look at the total credit outstanding in the economy:
Do you see that tiny decline over the last couple of years? That is the amount of debt deflation that we have experienced. It is tiny in the big picture.
Think about the huge market dislocations that this debt deflation caused in 2008. Then think about the sustainability of this credit expansion.
Ask yourself if the economy is more or less balanced today than during the 1994–2002 period. Does volatility really deserve to be at all time lows?
Or is this a case of the Federal Reserve (and all the other Central Banks) suppressing volatility again? And do they really think that somehow this time will be different?
Actually, I take that back… it will be different… The crisis will not look the same by any means. Investors will be focused on the same issues that bit us in the ass last time, and they will not realize that the problems are much bigger than last time. In 2008/9 the Federal Reserve had a lot of room to reflate the economy with their balance sheet. This time, the Federal Reserve is going to be the problem.
I can’t believe that we are here again, but the all time lows in volatility is not the reflection of a stable economy, but instead the misguided attempts by the Federal Reserve to control the business cycle. Their attempts will be even less successful than the last time.
As Minksy noted nothing is more destabilizing than stability – especially when it is an artificially created Federal Reserve induced stability. As we stumble down into artificial new lows in volatility the risks are increasing exponentially. Be careful. Don’t let the Fed’s illusion of stability blind you to the fact that the economy has probably never been more precariously balanced.