Saturday, April 9, 2016

Volatility on downtrend - volatility spikes tied to liquidity

Asset price volatility follows a pattern of spiking only to then gradually decay. This is the essence of much of the GARCH modeling revolution. The patterns for volatility behavior is well-defined. The key issue is what causes the spikes in volatility. A simple answer is market uncertainty, but it is hard to determine what is uncertain versus what could just be a surprise. Surprises are unanticipated but may not be the same as uncertainty. Surprises will cause spikes in return, but they may not always lead to persistence in volatility. 

Many volatility spikes are related to changes in liquidity as defined by money in the credit channel. A decline in money through increases in rates will cause reduction is risk-taking and change the discount factor used to price assets. This will lead to higher volatility which will decline as the market adapts to the change in liquidity conditions. Increases in liquidity will not generally lead to increases in volatility. Decreases in liquidity will lead to volatility spikes because risky assets will be sold. Increases in liquidity will dampen volatility. 

Stock volatility has declined after the surge from the Fed rate increase. Since January there has been a dampening in volatility associated with increases in liquidity by other central banks and the potential delay by the Fed. Now the null hypothesis on volatility spikes is that there will always be a dampening after a volatility surge, but the increases are greater on liquidity decreasing shocks. The speed of the decline will be associated with the reversal in liquidity tightening.

With this view of the world, volatility will stay low until the next liquidity spike. 

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