Saturday, February 10, 2018

More than just equity volatility, look at bonds - The Big Volatility Revaluation

The highlight of the 2018 is the Big Volatility Revaluation. While not as dramatic, the increase in bond volatility has been just as surprising and has correlated with the VIX index. The MOVE (Merrill Lynch Option Volatility Estimate) is a bond risk index developed by Merrill Lynch using a similar methodology as the VIX of creating an index using the implied volatilities of bond options. This should be a more useful method for determining current market expectations of volatility embedded in prices than backward-looking historical standard deviations.

Notice the bond volatility spike started around the same time as the VIX, however, it is still below the highs earlier in the year. It has seen a 50% increase since the lows in mid January. Stock volatility may be more susceptible to spikes given the bond markets are usually driven more by institutional players than stock markets

The increase in volatility of both stocks and bonds has meant havoc for risk parity managers and systematic managers who control risk or size positions based on current volatility. For portfolio risk management purposes, position-sizing could have been decreased this week independent of fundamentals or price moves. 

A longer-term view of MOVE volatility suggests that this current spike is strong but less out of the ordinary relative to equity volatility as measured by the VIX; nevertheless, the current change places the MOVE closer to, albeit still below, long-term moving averages. What is consistent with the MOVE spikes is that they are associated with recessions, financial crises, or Fed surprises. There are also secular trends in volatility such as the post Financial Crisis decline during Fed intervention. A return to normalcy is likely to generate MOVE values that are higher.

There is a tendency for both VIX and MOVE volatility to spike and then trend lower, a pattern that has been found in all markets and historic periods. The market concern should be the revaluation of volatility to higher averages consistent with an environment with more central bank normalcy. The result of a more normal volatility environment closer to long-term average will be less leverage-taking by traders and a general change in asset allocation from less aggressive risk-on behavior.

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