At a Glance
- In 11 Fed easing cycles since 1972, equity volatility rose in the three months prior to the first rate cut.
“Don’t fight the Fed” is such a wizened market phrasethat the temptation is to ignore it. But for U.S. equities it seems that the Federal Reserve still has magical powers. Between late September and Christmas 2018, the S&P 500 index fell by 20 percent. Back then the market was pricing three rate rises for 2019.
Those rate rises were taken off the table by January’s surprisingly dovish FOMC statement. The sentiment was reinforced following the Fed’s March meeting, where they indicated no rate increases are coming in 2019.
The equity price rally since January has been impressive and so has been the fall in cross-asset class volatility. Equity volatility and credit spreads have fallen for two consecutive months, something not seen since 2014 and Bank of America Merrill Lynch’s proprietary measure of market risk and volatility has recorded its biggest fall since Mario Draghi’s “whatever it takes” speech in 2012.
How Dull Is It?
It is so dull out there that 2017 springs to mind. That was the year in which the VIX index was comatose, the S&P 500 rose in a metronomic-style every month and the iBoxx (credit) index spread to German bunds got stuck at 7 basis points or lower.
Long equities/ short volatility, effectively selling an option, would also have been a highly remunerative trade so far in 2019. But investors who view this as the same trade with different, diversifying risk premia may be overly complacent. U.S. and European interest rate rises are seemingly no longer on the agenda. But rate cuts could be, as soon as 2020, according to Fed funds and Euribor futures.
Equity Volatility and Rate Cuts
In the past 11 Fed easing cycles since 1972, equity volatility rose materially in the three months prior to the first rate cut. The largest rises in volatility have tended to be associated with financial shocks – such as Black Monday (October 1987) and the Long Term Capital Management collapse (September 1998) – when the “Greenspan put” was then deployed to support markets. But a general deterioration of economic conditions leading to an interest rate cut has also seen equity volatility rise ahead of a cutting cycle back to 1972.
In addition to cyclical factors suggesting volatility may rise, structural forces should not be ignored. For reasons beyond the scope of this article, markets seem to be more susceptible to short, sharp shocks. In August 2007, the former chief financial officer of Goldman Sachs, David Viniar, explained a sharp sell-off in his firm’s long-short quant funds as “25-standard deviation moves, several days in a row.”
This quote has rightly been used to deprecate the idea that normal, Gaussian distributions are applicable in financial markets. Events since, including the May 2010 “flash crash” and February 2018 volatility tsunami, have reinforced the view that markets are more fragile and not as readily explainable as some quantitative models may have assumed.
More S&P Volatility Since 2015
U.K.-based hedge fund Neuron Advisers has recently written a paper that looks at the volatility of the S&P 500 index between its inception and 2015 and the period since. It uses a first order statistical measure of volatility – one-day returns more than five standard deviations greater than the daily average returns in the prior month.
These moves have become much more ubiquitous. There have been four sudden market moves between the beginning of 2016 and today, versus just 14 in the prior 55 years. To most mainstream investors these manifestations of volatility, cash index price moves, will be more meaningful than the bizarre events of February 5, 2018 that saw VIX futures surge 97 percent.