Markets for equities, bonds and currencies are the calmest they’ve been since 2007, and that’s making some investors nervous.
Options that protect against Standard & Poor’s 500 Index losses plunged 64 percent in the last two quarters, the most ever, data compiled by Bloomberg show. Interest-rate volatility is near a five-year low, while demand for hedges against extreme moves in the dollar is close to the weakest since 2008. Bank of America Corp.’s Market Risk cross-asset volatility index reached a level not seen since November 2007.
Becalmed markets have fooled investors before. The Chicago Board Options Exchange Volatility Index fell to a 13-year low of 9.89 in January 2007 before the financial crisis of 2008 wiped $37 trillion from share prices worldwide. As the gauge of options prices slipped within 5 points of that level last week following a 28 percent S&P 500 rally, demand has risen fivefold for exchange-traded products whose value increases should volatility rebound.
“Nobody is scared right now, but the fear will come back,” Sean Heron, who manages options strategies at Glenmede Trust Co., said in a March 30 phone interview. The Philadelphia- based firm oversees about $20 billion. “All bets are off as soon as we get beyond the next three months. Europe could rear its ugly head again and it’s an election year in the U.S.”
Bank of America Merrill Lynch’s indicator of cross-asset volatility, a component of their Global Financial Stress Index, fell to minus 0.41 on March 29, down from a positive reading of 0.28 at the beginning of the year. It touched minus 0.48 on March 2, its lowest level since November 2007, just before the U.S. economy was about to enter an 18-month recession and a month after the S&P 500 reached a record high.
The index is a measure of future price swings implied by option markets in global equities, interest rates, currencies and commodities. A negative number means lower-than-normal volatility expectations based on data going back to 2000.
“The rally in risk assets combined with the liquidity support provided to the market by central banks have acted to depress volatility,” Benjamin Bowler, San Francisco-based head of global equity derivatives research at Bank of America Corp., said in a March 29 phone interview. “If the recent strength of the U.S. economy begins to fade and markets roll over, then I would expect to see a rise in volatility.”
The VIX averaged 18.04 from January through April 2011, falling to 14.62 on April 28, a day before the S&P 500 peaked and began a 19 percent decline that lasted until Oct. 3. The S&P 500 moved 1.3 percent a day from April through December, compared with a 50-year average of 0.6 percent before the collapse of Lehman Brothers Holdings Inc. in 2008.
Investors have been appeased so far in 2012 as central banks from Europe to the U.S. and Asia try to speed the recovery from the first global recession since World War II. The Federal Reserve pledged to keep rates near zero through at least late 2014, while the European Central Bank gave banks more than $1 trillion of three-year loans. The Bank of Japan (8301) unexpectedly added 10 trillion yen ($120 billion) to an asset-purchase program in February.
Improvements in U.S. payrolls and consumer confidence pushed the S&P 500 to its biggest first-quarter rally since 1998. It advanced 12 percent in 2012 to 1,408.47 on March 30. The VIX slid a record 66 percent since its Oct. 3 high to 15.5 on March 30, below its 22-year historical average of 20.54. The gauge, which touched its lowest level since June 2007 on March 26, gained 0.9 percent to 15.64 in New York today. Europe’s VStoxx Index fell 5.9 percent to 21.22 today.
“The current equity volatility environment is supremely challenging,” Jeremy Wien, head of VIX trading at JPMorgan Chase & Co. in New York, wrote in a March 30 e-mail. “Do we buy volatility at low levels relative to the last few years because of the headline risks, or do we sell volatility because the market is hardly moving?”
Investors have piled into exchange-traded products, or ETPs, betting the volatility decline won’t last. The number of shares outstanding for 17 of these products that increase when the VIX rises has jumped more than fivefold this year, according to data compiled by Bloomberg.
Shares (VXXSO) of the Barclays Plc’s IPath S&P 500 VIX Short-Term Futures ETN (VXX), the largest ETP that climbs when the VIX increases, jumped fivefold this year to a record 114.3 million on March 23, boosting its market value to as much as $2.18 billion on March 19. The price of the note is down 53 percent this year.
Demand for Credit Suisse Group AG’s VelocityShares Daily 2x VIX Short Term ETN (TVIX), known by its ticker symbol TVIX (TVIXSO), pushed shares outstanding to 54.2 million, up almost 11-fold since the end of last year. The Zurich-based bank on Feb. 21 stopped issuing shares “due to internal limits on the size of the ETNs,” according to a statement at the time. The market capitalization of the note reached almost $700 million on March 6. The TVIX, which lost 77 percent this year, aims to generate twice the daily return of an index tracking VIX futures.
Swings (USGG10YR) in Treasury yields have been subdued as the Fed’s pledge to keep borrowing costs low anchored short-term rates and concern about European sovereign-debt crisis made investors reluctant to sell U.S. debt. The 10-year Treasury (USGG10YR) yield moved between 1.79 percent and 2.16 percent in the four-month period ended Feb. 28.
Bank of America Merrill Lynch’s MOVE Index (MOVE), which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, fell to 69.9 basis points on March 12, the lowest since July 2007. The index ended last week at 78.6 basis points.
“The potential for more quantitative easing has grown over the last week,” Brian Svendahl, Minneapolis-based senior portfolio manager of fixed income at RBC Global Asset Management Inc., said in an interview on March 29. His firm oversees more than $250 billion in assets. “We are likely a few data points away -- or even a European explosion away -- from more monetary accommodation.”
Wall Street’s largest bond trading firms think the worst is likely over for the Treasury market as the pace of economic activity wanes amid U.S. budget cuts and $100-a-barrel oil. After reaching as high as 2.4 percent, the 10-year Treasury note yield ended the quarter at 2.21 percent. The yield on the benchmark 10-year note will finish 2012 at 2.48 percent, according to the median estimate in a Bloomberg News survey of the 21 primary dealers that trade with the Federal Reserve.
Stability in global interest rates helped damp swings in exchange rates over the quarter. A simultaneous fall in options prices and demand for hedges suggests currency derivatives investors may also be underestimating the risk of broad swings in foreign-exchange, according to Caio Natividade of Deutsche Bank AG.
Extreme Currency Moves
A gauge of the demand for hedges against extreme currency moves in the dollar against the euro, known as the option butterfly, is near a low touched in March 2011, which was the lowest since September 2008, before the collapse of Lehman Brothers Holdings Inc. Implied volatility of options that protect against fluctuations in developed nations’ currencies is 10.04 percent, just above 9.71 percent touched in February, the lowest since August 2008, according to a JPMorgan Chase & Co. index.
“There clearly seems to be some underestimation of risk in the markets,” Natividade, the London-based head of foreign- exchange quantitative strategy for Deutsche Bank, said in a March 29 interview. “People may think we are in a new paradigm of low volatility, but that is not what we expect,” said Natividade, whose firm is the world’s largest currency trader, according to Euromoney Institutional Investor.
Euro’s Quarterly Gain
The euro had its biggest quarterly gain in a year against the dollar during the January to March period, after European finance ministers agreed to boost an anti-debt-crisis firewall, adding confidence the region’s financial problems are abating.
The euro ended the quarter at $1.3343, up 2.95 percent from $1.2961 at the end of December. The Dollar Index (DXY), which Intercontinental Exchange Inc. uses to track the greenback against the currencies of six U.S. trading partners, fell 1.5 percent during the quarter to 79.004.
Global central banks’ steps to boost liquidity have reduced the odds of a large shock to the market such as the one that followed Lehman’s bankruptcy, said Nelson Saiers, who oversees about $650 million as chief investment officer at Alphabet Management LLC in New York.
“The markets have a tremendous buffer,” Saiers, who uses options to bet on the volatility of global stocks, commodities and currencies, said in a March 29 phone interview. “Governments have been exceedingly willing to do what they can to prevent a crisis.”
U.S. employers boosted payrolls more than forecast last month, capping the best six-month streak since 2006. Confidence among consumers unexpectedly rose in March for a seventh straight month, climbing to a one-year high, the Thomson Reuters/University of Michigan’s final index showed on March 30.
Traders are betting volatility will jump from its almost five-year low. Ownership (VIX) of VIX calls rose to a record 4.22 million on March 20, while put open interest was 3.06 million, data compiled by Bloomberg show. VIX futures expiring in six months on March 16 traded at a record high versus the index, and the contracts on the measure touched an open interest of 355,393 on March 20, the most ever, the data show.
“You must try to gauge what the likely catalysts for a sea change are,” Daragh Maher, a currency strategist at HSBC Bank Plc in London, said in a phone interview on March 29. It’s “entirely conceivable that Europe throws out some other kind of banana skin that gets markets all energized again.”
To contact the reporters on this story: Nikolaj Gammeltoft in New York at firstname.lastname@example.org; Liz Capo McCormick in New York at email@example.com; Cecile Vannucci in Amsterdam at firstname.lastname@example.org