Financial markets went through a phase of extreme volatility last year. Stock markets fell by over 30% in a month, and implied volatility moved to levels not seen since the Global Financial Crisis, with the VIX above 80%. The selloff was followed by a strong rebound, which brought indices back to pre-crisis levels by the end of the year. Bond markets have been very volatile, too. Sovereign bonds rallied strongly at the peak of the crisis, followed by a bear market. As a reference, the Bloomberg Barclays US Long Treasury, which aggregates Treasury bonds maturing over 10 years or more, is down by 26% year-on-year. Credit spreads have moved up and down quite significantly over the same period. The oil price deserves an award in the volatility contest, with the 1-month WTI contract moving from $50 to $15 in one month and actually turning negative (-$40), due to an unprecedented glut at the Cushing hub for a couple of days. Did these extreme asset prices movements reset market volatility higher for a prolonged period?
In fact, they did not. Although bond market volatility remained high in the first quarter of 2021, due to higher-than-expected growth and inflation prospects on the back of US stimulus plans and accelerated vaccination rollouts, equity and credit volatility came down sharply.
Previous market moves over the past two decades have generated short-term spikes in asset price volatility but have not changed the volatility regime and average levels over longer periods. For example, in the European context, Brexit or the Euro crisis triggered volatility spikes but both realised and implied volatility came down quickly soon afterwards across asset classes, including sterling or Eurozone periphery bonds. Therefore, these shocks in isolation have not been be enough to reset market volatility higher, largely because the “whatever it takes” fiscal and monetary response managed to calm investor fears.
Last year, asset price volatility was the consequence of an economic crisis, which deserves all superlatives. Yet if cross-asset volatility has come down very quickly, it is because the fundamental backdrop does not allow otherwise or because market participants believe that the “Great Moderation” regime is still prevalent. Therefore, the Covid-19 crisis will be a turning point towards a higher volatility regime only if one or several factors, which define this regime (and drive volatility) change post-crisis.
Asset prices in aggregate could be more volatile than in the “Great Moderation” regime going forward for at least two reasons: (1) shorter and /or more volatile economic cycles; and (2) lower diversification across the asset classes.
1.If “good luck and good policies” disappear at the same time with no strong-enough rebalancing mechanism, we should expect shorter, more volatile and even desynchronised economic cycles. One consequence would be unstable bond yield curves, with shorter steepening and flattening cycles, and therefore an unstable discount factor. Shorter economic cycle’s means more volatile corporate earnings, and companies will find it more difficult to issue long maturity bonds as investors will ask for a higher premium to hedge against a shorter default cycle. In this context it’s probably the volatility of volatility that could be higher.
Over the past decades, various shocks have generated temporary spikes but have not been be enough to reset market volatility higher, largely thanks to fiscal and monetary responses.
2.The second changing factor could be lower diversification. The main source of diversification across financial markets is the negative correlation between sovereign bonds and equities. This negative correlation established since the middle of the 1990s acts like a shock absorber. Central banks emphasise this absorbing mechanism in lowering policy rates and buying long-term bonds via QE. But both the negative bond/equity correlation and monetary easing are possible in a low inflation regime where inflation expectations are well anchored within a long term deflationary trend. The end of the ”Great Moderation”” could be an environment where inflation is higher than the past two decades and inflation expectations unanchored. In this environment, the correlation between bonds and equities is close to zero or positive (except in phases of equity market sell-offs). Central banks will not be able to keep loose monetary policies over long periods, and balanced portfolios will be less protected by their bond parts. Therefore, investors will tend to switch on and off their equity positions using cash to reduce risk, which leads to higher volatility of the equity market.
The Covid-19 crisis could be a turning point towards higher volatility of the economic cycle and/or a shift to a higher inflation regime. Those factors are likely to lead to higher financial market volatility than in the previous two decades. However, until the shift is confirmed, investors will remain in the “Great Moderation” paradigm, bringing asset price volatility back to its low average levels.
Unstable bond yield curves and unstable equity/ bond correlation would be the main consequences.