Three Reasons Volatility Might Increase

Where art thou volatility? Not here, nor there, but soon to revive, me thinks.  Volatility in risk markets is simply the measurement of variation in prices which is often calculated over certain time periods and against the idea of a normal distribution. The most important markers are historical (statistical) volatility and implied volatility. Historical volatility is a retrospective measurement of actual pricing variations whereas implied volatility is the theoretical price of an asset taking into account actual prices, historical volatility, a time component and the risk free rate within a pricing model such as the Black-Scholes model. Both historical and implied volatility have recently declined to cycle lows in many asset classes. The consensus call is for continued calm waters. This call for tame volatility may be underestimating three potential drivers to higher volatility this year: rising inflation and Federal Reserve policy, a taper tantrum and geopolitical unknowns.

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The most popular measure of market volatility in the US is the CBOE Market Volatility Index (the "VIX") which is also known rather ominously as the "fear gauge."  The VIX measures a weighted average of the implied volatility of a wide range of S&P 500 options with a 30 day maturity.  Quite simply, the VIX is the implied volatility of the S&P 500 and is frequently thought of as the market's broad expectation of volatility over the next 30 day period. The VIX has been on a downward trajectory since 2010.

The VIX has an audience across asset classes as it can give insight into the short term biases and leanings of US equity market participants.  To be clear, the VIX is one tool to measure perceived volatility and although a high VIX or an upward trend is most often the result of a declining equity market, the gauge can increase as well when call holders refuse to sell options absent a larger premium.  Thus, the VIX can be a measure of upside or downside moves with higher numbers representing the anticipation of sharper moves. Somewhat ironically, there are many instances where higher VIX prices correlate strongly to higher prices in the S&P 500 as the fear dissipates and markets readjust.

The VIX and other measurements of volatility have continued to trend down for many reasons including the fact that the world's central banks have maintained highly accommodative monetary policies.  The European Central Bank has just announced a program of direct asset purchases including the cessation of the "sterilization" of their current markets program. Moreover, secondary central banks like the Bank of Mexico have cut rates in an effort to spur higher inflation.  Assuming a direct correlation between liquidity and volatility, all of these programs should act as a governor to higher volatility. Other reasons offered to explain the calmness in markets include exceedingly low trading volumes, range bound markets, recently improving economic data and fewer economic surprises, the transparency of corporate reporting, and the perception that there is no immediate catalyst to drive volatility higher.