The price action in risk assets in Europe and the U.S. yesterday was a fairly typical “risk off” day, the kind we had sort of forgotten. Strong dollar, strong treasuries, weak oil, down day in equities, while the VIX had its largest increase in more than a month.
On Friday in this space (MorningWord 5/22/15: $VIX – Do You Realize??) I highlighted the difficulty of owning options premium given the low levels of realized volatility, but suggested that the borderline extreme movement in almost every other risk asset class than U.S. equities could be signaling an impending sea change in how investors view future equity returns:
as we get closer to the FOMC raising interest rates? It feels that way as rate have risen of late and almost every other major risk asset in the world has seem some fairly real volatility, commodities, currencies and of course bonds, while the largest equity market on the planet grinds higher with a sort of complacency that has flecks of reckless abandon.
On numerous occasions in the last few months we have highlighted the 10 day realized volatility in the S&P500 (SPX), when it reaches mid-ish single digits on the downside we have usually seen a sell off in stocks. Since early September, all three prints below 5 have resulted in significant sell offs, peak to trough of nearly 10%, 5% and 4% in October, December and March respectively.
While charting volatility is a fairly useless endeavor, what’s clear is that SPX short dated realized volatility is making higher lows and lower highs as a result of the decreasing size of the corresponding sell offs.
But what does this pattern suggest for the near future for the SPX? We have to learn the recent lessons of other asset classes. Without the vol dampening effect of QE and ZIRP, we could be in for a fairly epic breakout in volatility in equities. The six year chart below of the SPX 10 day realized vol shows the potential for stocks to move when the central banks have far less control then they do now:
The Fed has acted as a vol seller in equities for years now. No one is sure what will happen to equities overall once the Fed backs away from ZIRP, but once they begin to, day to day and week to week volatility will likely be one of the first changes of note.