Sunday, August 10, 2014

Stock volatility and macroeconomic volatility

The volatility of stocks and other asset classes are currently low by historical averages. However, there are some very reasonable explanations for this low volatility and why it may extend. It is related to volatility in the macroeconomy.

There are other factors that could drive volatility, but business cycle risk is a key determinant for low volatility. Yes, volatility will be mean-reverting but only because the volatility of macroeconomics is mean-reverting. However, if there is an extended period of low macro volatility we should see the volatility of stocks also stay low. The period of the Great Moderation in the macroeconomy was a time of low volatility. It was punctuated by crises, but the VIX index was generally range-bound. If central banks and governments around the world attempt to dampen volatility, there will be a corresponding dampening of stock volatility. It seems as though controlling the variation in macro-variables has been one of the policy objectives. Hence, we will not see an extended period of high VIX levels until the underlying components of macro economy get more volatile. We will have to see more two way changes or variability in consumption, investment and labor to get the asset  volatility higher.

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