Volatility

Market turmoil in May and June has not been sustained. Financial market volatility has fallen back to multi-year lows. Is this reduction lasting?

According to a recent study by the Bank for International Settlements, volatility from mid-2004 to March 2006 was notable because it was low for a prolonged period, simultaneously, across different assets in both industrial countries and emerging market economies. The BIS believes part of the reduction is structural.

The argument that the shift by central banks towards monetary policy gradualism and greater transparency has reduced the volatility of short-term interest rates has intuitive appeal and could be durable.

Less convincing is the BIS’s suggestion that increased market liquidity and greater participation by institutional investors has permanently dampened volatility. Reaching this conclusion as central banks are withdrawing liquidity after a period of very cheap money appears premature. A lesson from the summer is that volatility rises if institutions change their minds en masse.

The BIS acknowledges the impact of cyclical factors in reducing volatility – the global economy’s sustained expansion and low inflation, as well as the improved health of corporate earnings and balance sheets. With the US economy slowing and corporate profits at peak levels, the economic outlook is deteriorating. Even if sharp surges, such as in May, are avoided, investors should not assume that low volatility is here to stay.