Traditional measures of volatility at historic lows and Wall Street stocks at new record highs went hand-in-hand in 2016 with traders fretting about bouts of wild stock-price swings and currency flash-crashes.
The past year has been nothing if not paradoxical for financial markets – a landscape that will probably persist in 2017.
The proliferation of automated trading and passive investing, extreme levels of speculative positioning in an increasingly regulated broking world suggest investors should brace for periodic turbulence even if markets are mostly calm.
While the measures of future or implied price volatility look remarkably subdued, they are disguising a minefield in individual securities and currencies, and – during particular periods – micro market storms that may become magnified as U.S. interest rates rise and other central banks step back from years of anaesthetising money-printing.
An analysis of intraday volatility across major equity, bond and currency markets shows that episodes of sudden, extreme market volatility has become more commonplace in the last two years, even though implied volatility has been contained.
With the world’s biggest investment banks shrinking market-making activities and balance sheets to comply with post-crisis regulations, the scope for sudden market shocks is rising.
“Trades often move in bigger size, quicker, and in blocks,” said Charlie Bristow, co-head of rates trading at JP Morgan. “The speed at which order book depth can go from high to low is a new phenomenon, and it won’t go away if volatility remains where it is.”
Officials at the Bank for International Settlements have said that the VIX index is no longer the default barometer of investor sentiment and risk appetite – that’s now the dollar – and that bouts of extreme volatility will be more commonplace.
Not much of a concern, Claudio Borio, head of the BIS’ monetary and economic department, says, along as such bouts pose no threat to institutions’ stability or market functioning.