Volatility Squeezed Higher

Numerous sources have commented on the low volatility in the past two years.  I thought the following was an excellent summary and interpretation of the phenomenon by Tim Price of Ansbacher & Co.  In his commentary, Price quotes John Taylor, Chief Investment Officer of FX Concepts, who addresses the dilemma in a recent market report, entitled ‘Low Volatility Now Means High Risk’ –

Taylor "goes on to argue that Greenspan is making a serious error of judgment in interpreting lower volatility as "the result of good Fed management which “encourages presumptions of prolonged stability” resulting in a low level of “perceived credit risk and interest rate premiums.” But, the low volatilities priced into the Treasury curve and credit spreads are a function of hedge funds. The real problem is this situation does not mean-revert. The tighter spreads get, and the lower volatilities become, the larger the trade must be to generate the same return, and the larger the trade the smaller the spread, forever. This trend is compounded by the growth in hedge funds."

As Taylor goes on to suggest,

"Because the hedge funds are selling volatility, the volatility curve now deviates far from a normal curve. It is leptokurtic, perhaps in the extreme, and what this means is the tails are very fat. Extreme events are far more likely than one would normally expect. In effect, this means that the lower the level of implied volatility, the more likely there will be an outsized realized volatility event in the future. The market will run wildly in one direction causing much distress and then there will be a group of hedge funds unable to get out of their positions. The preponderance of long volatility traders in the currency markets means they will be better behaved.

"We see real risk in the equity and fixed income markets, not the foreign exchange market.."

It is certainly a weird systemic wrinkle in the fabric of capital markets when investors / speculators looking to reduce their own risk – by hedging their positions – are ultimately compounding risk for everyone in the market. As US interest rates continue to rise, and if bond prices react logically in time-honoured fashion, the dangers of leverage will become more apparent. Allied to those anticipated but unforecastable "extreme events" and a general overcrowding in any number of specific strategies, the prognosis seems clear.

As John Taylor implies, low volatility is not a sign of a low risk environment, but something to be afraid of. With so many markets apparently priced for something close to perfection even in the face of obvious macro storm clouds (see more on the ongoing deflationary Asian supply push, for example, below), there is more merit than usual in taking a defensive posture in both asset allocation and individual investment terms. Or to put it more prosaically, enjoy the party but dance near the door.

The reason I bring this up now is that it looks like volatility is starting to break out.  It could be the beginning of the end of the volatility squeeze.  The VIX appears to have made the first "higher low" in a long while.