Once upon a time, trading floors had a brash charm. On days like sterling’s exit from the European Exchange Rate Mechanism there was no better place to watch the drama of markets unfolding. No more. The latter-day trading floor is more sepulchral than theatrical. Within these (quiet please) cathedrals to Mammon, traders in smaller and smaller silos buy and sell ever more niche products silently, over electronic networks. They scarcely pass the time of day with their colleagues on other desks, let alone hoot ’n’ holler at them.
The leeching of colour from the trading floors of London and New York is also a reflection of markets. They are boring; almost excruciatingly so. The US equity market is behaving as if it were suffering from an extended narcoleptic episode. A report last month by US research firm Birinyi Associates said that the Dow Jones Industrial Average had not suffered a drop of 2% or more since May 19 2003. This is an interlude of tranquillity unmatched since 1900.
The Vix Index of US stock market volatility went down in 2006 as the Dow Jones, slowly, predictably and smoothly, went up. Between 1998 and 2003, the Vix traded in the mid-20s. In March 2006, the index was trading below 11 and in spite of a sharp rise following the swoon in emerging markets in May and June, peaking at 23 on June 13, was back below 11 by mid-October. The Vix Index has only closed below 10 eight times since it began trading in 1990; three of those were in the last two months of 2006.
For a trader who likes life in the fast lane, surely the world of FX offers a respite from this snooze-athon? Nope. During the 1990s, the average one-month at-the-money implied volatility of options on dollar/Deutschemark traded in double digits. In 2000, the first year of the euro, the average dollar/euro one-month implied volatility was 13%. By 2005 volatility had declined to an average of 8.7% and last year it was around 8%. There has been a similar decline in dollar/yen implied volatility.
The disappearance of volatility across different asset classes is perplexing. Some commentators regard it as a purely cyclical phenomenon. Sections of the academic literature suggest that volatility strikes from a blue sky, rather like an England XI winning a cricket match in Australia. However, there are surely structural forces at play. As the great detective Sherlock Holmes said: “Singularity is almost invariably a clue. The more featureless and commonplace a crime is, the more difficult it is to bring home.”
To solve the strange case of the death of volatility it might pay to focus on the singularities and ask what has changed in financial markets since 2000. In the FX world one big change has been the form and function of central banks. The accumulation of foreign exchange as tracked by the IMF’s Cofer database has been remarkable, growing from $1.8 trillion at the start of 2000 to $4.7 trillion at the end of the third quarter of 2006. No central banker wants its currency making sharp moves, and central bankers have greater firepower than ever to moderate volatility.
The interaction of central banks with the market has also changed. Nobel Prize winning economist Robert Solow once compared central banks to squid: “They emit ink and move away.” That was true when second-guessing the machinations of Eisuke Sakakibara (Mr Yen) and his central banking peers could whip-saw markets. But today the watchword is transparency. Even the once obscurantist Bank of Japan laid out a clear timetable when it announced the end of quantitative easing last March.
However, the biggest new, new thing in markets across asset classes is hedge funds. In 1990 their assets were $40 billion, by 2000 that had grown to $456 billion and by the end of last year to $1.2 trillion. It is interesting to consider whether hedge funds have added to the diversity of markets or detracted from it.
The ability to go short, leverage and trade across cash and derivatives sets them apart from traditional institutional money. But scratch the surface. The information hedge funds have access to and the investment processes they deploy are more similar to long-only funds than different and that is becoming ever more the case. The commonalities between hedge funds and institutional money managers look even starker when either group is compared with retail investors. The impact of these investors, truly holders of heterodox views, has been all but neutered by a new, leveraged $1.2 trillion kid on the block.
There are sound structural reasons why volatility has fallen. However, central banks have not lost their capacity to surprise, as the Bank of England recently demonstrated. The idea that hedge funds are a force for lower volatility will also surely be tested in 2007, when something ugly is likely to emerge from the swamp of structured credit. This column made one investment prediction in February 2006: that emerging markets would outperform developed ones over the calendar year. Emboldened by that correct call, we now make two. Volatility will increase in 2007 and so will the volatility of volatility. Who knows, trading floors might even become interesting again.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own