Pick up an old book on investing — pre-1990 perhaps. Run your finger down the index. You will find no end of interesting bits and bobs under the letter “v” such as VAT, vendor placing, and mentions of a “gunslinger” fund manager called Peter de Vink.
What you won’t find is volatility. It wasn’t a thing back then. Sure, brokers referred to the odd day as being more volatile than others when they strolled into their panelled board rooms at 10-ish of a morning. But they did not trade volatility; they did not invest in it; they did not make its level the centrepiece of their investment strategy; they did not short it; and they most certainly did not refer to it as “vol”.
Times are different now. If you have been listening to the media coverage about the mini-correction in markets this week, you will have heard of almost nothing else. It has been non-stop volatility gaga, volatility googoo. So what’s it all about?
It started in a simple way. In the late 1980s, a couple of finance academics, Menachem Brenner and Dan Galai, introduced the idea of an index that would effectively measure market expectations of how much the stock market might or might not wiggle around — and allow people to hedge against that change. (The full paper is here — if you want to stop your head exploding, only read the first few paragraphs).
With the introduction of futures and options to the market, the authors noted, it had become relatively straightforward for investors to hedge against sharp changes in the direction of particular investments. But they had no way to hedge against changes in the overall ups and downs of the market. In the aftermath of the 1987 crash, there were fears that “the public might shy away from investing in risky assets because of the perception of enhanced riskiness”. So surely offering people an index that would let them hedge away all the scary short-term movements within a trend was a pretty good idea?
The industry agreed. Following some discussion in the early 1990s, the Chicago Board Options Exchange launched one — the Cboe Volatility Index or Vix for short. So far, so straightforward. But then, as the Cboe put it, “several investors expressed interest in trading instruments related to the market’s expectation of future volatility”.
Of course they did. Enter Vix futures (2004), Vix options (2006) and a variety of exchange traded notes and funds focused on those derivatives. Anyone who thought that the world’s markets were going to be serene and stable could short volatility (bet on there being less of it). Anyone who thought things were going to be more fraught could go long volatility (bet on there being more of it). The stage was set.
Today, says Duncan MacInnes of investment management firm Ruffer, this “once obscure financial metric” has morphed from a simple barometer of financial stress into a “widely used input for many investment strategies”.
The problem? Most of those strategies have long had the same directional bias embedded in them. Earlier this month, Mr MacInnes reckoned that there was some $1tn invested one way and another in assets using strategies “designed to make money as volatility falls”. By last month, the Vix had hit all-time lows.
Old-timers bored of telling everyone that bitcoin was a bubble had started to point out that we were also in a low volatility bubble — or to put another way, a huge bubble in complacency. The Vix had been falling for so long that volatility really had nowhere to go but up, and that if it headed back to more normal levels (“substantial instability” is normal for the US market, noted Brenner and Galai in 1989) an awful lot of people would lose an awful lot of money.
So it proved. On Monday, strong wage growth in the US and tight labour market data combined to make markets worry that interest rates might rise faster and further than expected. Volatility spiked (the Vix doubled); traders who had spent the past few years making fortunes betting that nothing would change in a hurry sold; and all sorts of instruments linked to the Vix fell by 80 per cent plus.
My guess is that a lot of you are not that bothered about any of this. You were not, and are not invested in any derivatives of volatility, but perhaps you should be interested — because perhaps you are.
The stability of markets over the past eight years or so — what has made being short volatility so lucrative — has been in large part driven by the understanding that they will be constantly supported by central banks. At the slightest hint of trouble, those at the top made it clear they were willing to use monetary policy to make sure no one lost money, regardless of how overvalued stocks become or how much debt there is in the system.
So, to the extent that you own equities of any kind that have benefited from this dynamic, you too have been “short vol”. This of course means that you too are vulnerable to losing money as that trade begins to tremble.
If, as labour markets tighten (as they are), wages rise (as they are starting to) and the risk of real inflation rises faster than everyone expects, then monetary policy will have to tighten faster than everyone expects. Bank of England governor Mark Carney said exactly that this week. Across the pond, the message was identical — although it was more a case of what the new Fed chairman Jay Powell didn’t say. He made no soothing comments at all as the US stock market fell sharply again on Thursday.
Once the market’s great stabilisers, the central banks may no longer be as dedicated to their market-supporting cause now that they have inflation to start worrying about.
I wrote a little last week about why I expect inflation to surprise on the upside, but the evidence is still piling up. The global economy is strong across the board with everywhere from Japan to the UK seeing tight employment conditions (we can clearly all stop worrying about robots stealing all the jobs for few years). The oil price has doubled from its lows. And inflation indicators everywhere keep coming in a little ahead of forecast.
This has been a gruesome week for lots of investors. Next week may be worse, or may be better. But either way I suspect that stock market historians will see this week as marking a few important changes.
It represents the final recognition by central banks that whether it was anything to do with them or not, deflation needs to disappear from their worry lists (for now, at least) and they might need to get serious about monetary tightening. Plus the recognition by investors that rising inflation will mean rising interest rates, and the consequent return of volatility.
Depending on just how seriously central bankers take their inflation-fighting briefs, it might also represent the beginning of the end of one of the longest bull markets most of us have worked in.
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