The end of volatilty

It seems like we are falling off the volatility cliff. The end of volatility may be upon us. Looking at some of the key volatility indices for major asset classes, we are finding that low interest rates and significant gains in liquidity is reducing risk in the markets. Look at the VIX index for stock volatility. It has been declining since the announcement of the ECB lending program and the dollar swap lines provided by the Fed. In the fixed income markets, as measured by the MOVE index, there has been a steady decline since November. In the FX markets, the JP Morgan currency volatility index has also been trending lower since the addition of dollar swap lines.

The markets have been signaled that liquidity will be provided to reduce market moves and uncertainty. There has been some resolution of uncertainty and better US economic numbers, but that could lead to higher volatility on the upside. Another story would suggest that central banks do not want any dramatic fall in a asset prices, but the market is not willing to fully increase its level of optimism.

Clearly, there has been a significant gain in financial markets over the last three months, but market gains do not translate to lower volatility. The central banks want more stability because that should improve market flows. Interest rates on the front-end cannot go any lower and there is not enough strength for them to move higher. Currency markets through intervention is reducing volatility. In equity markets, the bets is more one-way because of the improved liquidity.

The low volatility is inconsistent with the view that there are significant macro risks. This cannot last for the longer-term because many of deleveraging problems by governments and consumers have not been solved.