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Calmest Markets in 12 Years as Fed Suports Confidence

Traders Work on the Floor of the New York Stock Exchange
Record corporate profits and faster-than-expected growth in housing and manufacturing pushed U.S. stocks to the biggest gain since 1997 last year as the Federal Reserve maintained asset purchases. Photographer: Jin Lee/Bloomberg

Markets for stocks, currencies, bonds and commodities are the calmest in at least 12 years amid investor confidence that central bank stimulus is spurring economic growth.

Expectations for price swings have fallen to the lowest on record for 29 assets, including U.S. equities, interest rates, the euro and oil, based on data since 2002 compiled by New York-based hedge fund Lake Hill Capital Management LLC. The implied volatility, a gauge of options prices, for the markets reached an average of 15.3 on Nov. 22, compared with an all-time high of 44.2 in 2008, data on two-month exchange-traded contracts show.

“Accommodative central bank policies have helped create a risk-on mentality, not just in equities but in global volatility in general across multiple asset classes,” Eric Metz, a derivatives strategist and fund manager at Chicago-based RiverNorth Capital Management LLC where he helps manage over $2 billion, said in a phone interview. “The question for 2014 is whether tapering will spur a rebound in volatility.”

Record corporate profits and faster-than-expected growth in housing and manufacturing pushed U.S. stocks to the biggest gain since 1997 last year as the Federal Reserve maintained asset purchases, while Japanese shares soared more than 50 percent as the central bank expanded stimulus measures. The Fed said last month that it will take the first steps to reducing the pace of bond buying as the labor market improves.

Volatility Indexes

Twenty of the 26 volatility indexes measured by CBOE Holdings Inc. fell last year with 17 gauges losing more than 10 percent. A measure of future price swings for Goldman Sachs Group Inc. shares fell the most among CBOE’s options measures, followed by crude oil and stocks. The Gold Volatility Index rose 51 percent last year for the biggest gain.

“It makes sense to prepare for a pickup in volatility this year,” Michael Strauss, chief investment strategist and chief economist at Commonfund Group in Wilton, Connecticut, said by phone. His firm oversees about $26 billion. “Investors will keep the overweight for equities but buy some insurance for that overweight to protect against the higher volatility.”

Equity Risk

The Chicago Board Options Exchange Volatility Index, or VIX, averaged about 14.2 a day last year, the lowest reading since 2006, data compiled by Bloomberg show. The gauge closed below its historic mean of 20.20 on all but two days of the year, ending 2013 at 13.72.

“This volatility collapse is concerning,” Jim Strugger, managing director and derivatives strategist at MKM Partners in Stamford, Connecticut, said in an interview. “U.S. equities are losing any semblance of risk.”

Bank of America Merrill Lynch’s MOVE Index, a measure of expectations for swings in bond yields based on volatility in over-the-counter options on Treasuries maturing in two to 30 years, was at 73.55 at the end of December. The gauge has averaged 91.88 over the past five years.

A JPMorgan Chase & Co. measure of global foreign-exchange volatility was 8.72 percent on Jan. 3, compared with 12.55 at the beginning of 2012. The bank’s index, which uses options to gauge the implied volatility of the most actively traded currencies and emerging markets, has averaged about 11.55 percent over the past five years.

The VIX fell 1.5 percent to 13.55 today after climbing 10 percent last week. Europe’s VStoxx Index added 0.9 percent to 18.17 following a gain of 9.3 percent in the prior week.

‘Accommodating Policies’

“Risky assets appear safer amidst global central banks’ accommodating policies,” Zem Sternberg, chief executive officer of Lake Hill Capital Management, said via e-mail. The New York-based hedge fund trades options on equity indexes and commodities. “This leads to complacency and in some cases excessive risk taking.”

Stocks of companies with weak balance sheets are rising twice as fast as stronger ones and junk-rated borrowers have gotten rates lower than their investment-grade counterparts did before the credit crisis.

A Goldman Sachs index of companies with weaker balance sheets rallied 50 percent last year, almost double the gain in a measure of more creditworthy firms. The New York-based bank uses a formula originally developed to forecast bankruptcies to put together the baskets.

Yields on dollar-denominated debt rated below BBB- at Standard & Poor’s have dropped below 6.5 percent, the same level as investment-grade bonds the week before Lehman Brothers Holdings Inc. failed, Bank of America Merrill Lynch index data show.

‘Critical Test’

The Fed has quadrupled its assets since 2008 with bond buying designed to reduce borrowing costs and boost economic growth, helping send the S&P 500 up 30 percent last year, the biggest increase since 1997. The central bank said in December that it had enough faith in the labor market to reduce monthly purchases by $10 billion and Chairman Ben S. Bernanke has promised to keep interest rates low.

“This year will be a critical test of how reliant investors are on the Fed’s asset buying,” Sternberg said. “This will make 2014 the most important year since 2008, when large-scale asset buying began.”

Volatility will remain low in 2014 as markets have shown the ability to withstand negative events and there are fewer catalysts on the calendar that can drive investor concerns, according to derivative strategists at Deutsche Bank AG.

Benign Conditions

“Market conditions appear benign as we enter 2014,” said the strategists, including London-based Pam Finelli, in a report to clients on Jan. 2. “Although a 5 percent-like pullback is quite possible over the course of the year, we do not foresee the need for protection against a major selloff in the coming months.”

The U.S. jobless rate fell to a five-year low of 7 percent in November, and gross domestic product expanded at a 4.1 percent annualized rate in the third quarter, the fastest pace since 2011.

A deterioration in the economy may revive market volatility, according to Stephen Stanley of Pierpont Securities LLC in Stamford, Connecticut. Data from China last week showed two measures of factory output declined while the non-manufacturing gauge fell to a four-month low in December.

Fed Bank of Philadelphia President Charles Plosser, an opponent of bond purchases by the Fed, has warned that central bankers may be too optimistic that they can smoothly pull back accommodation, including raising the main interest rate held near zero since December 2008.

“The volatility inducing event into 2014 might actually be that the economy is not as strong as people think,” Stanley said in a phone interview. “Everyone is positioned for almost like the best case scenario for the economy now.”

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