It’s a question that continues to bother grey-haired observers. Pan-asset-class volatility has been absent for a long time but is now returning. Its absence made little or no sense because uncertainty should be the one feature of markets that can be relied on. Several observers have recently argued that hedge funds are the cause. Fitch says with some cogent arguments that leveraged liquidity is a key reason.
The absence of volatility is a mixed blessing. While conventional traders might like nicely trending markets, the more savvy are meant to relish market instability – that is, after all, when dislocations and opportunities become apparent. Until this year, volatility had been fleeting and generally seen as an opportunity to go long again. Not any longer – the sheer number of senior bankers looking for a sign that the credit cycle is set to turn is generally overwhelming. They worry about sub-prime and leveraged loans especially, and the recent shake-up in US treasuries, where the 10-year yield is now 5%, was another red signal.
There tends to be some seasonality to volatility: for the past few years the summer months have been jittery for financial markets – although the old adage that you should sell in May and not return until October would not quite have worked out because of the rapidity with which markets have snapped back to previous levels. So will this summer be the one that gives financial regulators sleepless nights?
Equities, bonds and almost all forms of credit have been extremely stable for years. Leaving to one side the impressive amounts of leverage that continue to be applied to the financial markets, there are other mechanisms by which vol can disappear. Hedge funds have to create higher than average returns to justify their existence and the relatively high fees they charge compared with traditional asset managers. Apparently, one tactic they have pursued with a vengeance is to sell volatility – across the board. Such strategies are not without risk, as recent events highlight. There is a rather crude market adage about writing options that Euromoney has used before but it is worth remembering: “eat like pigeons, shit like elephants”.
