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In summer of turmoil, subdued 'fear' gauges make markets uneasy

[July 28, 2020] By Olga Cotaga and April Joyner

LONDON/NEW YORK (Reuters) - Financial markets' fear gauges are not flashing red at a time of serious global turmoil, stirring investor doubts over whether the indexes are mispricing current and future turbulence.

Volatility gauges embedded in option markets are used by traders and investors to predict -- or guess -- market direction. They can also be useful barometers of the economic and political mood, hence the VIX equity volatility index is dubbed Wall Street's fear gauge.

These indicators have dropped dramatically since March after global central banks floored interest rates and doubled down on money-printing to combat the coronavirus-led downturn.

The VIX, which uses options on the S&P 500 to track volatility over the coming month, has drifted below 25, after spiking above 80 <.VIX> in March.

Deutsche Bank's index of currency volatility <.DBCVIX> slipped below 6%, more than halving from March's record highs despite euro-dollar implied, or expected, volatility ticking higher on back of dollar weakness.

The drop on Treasury bond volatility is even more dramatic <.MOVE>.

Good news surely: low volatility is usually a precursor to equity gains and a green light for investment into riskier currencies.

Yet there are still major risks facing investors -- a raging pandemic that threatens U.S. and global economic recovery, November's U.S. presidential elections and China-U.S. tensions.

NatWest analyst James McCormick describes the calm as an unstable equilibrium, which may soon end if a plunging dollar triggers volatility across asset classes.

"In a world that is experiencing an unstable equilibrium, policymakers can plug a few holes in the volatility dike, but ultimately volatility will show up somewhere else," McCormick said.

"Dollar weakness may be an example of volatility escaping from the leaky dike."

Underlying investor unease also shows up in record-high gold prices, and hefty flows into cash and bonds.

Luca Paolini, chief strategist at Pictet Asset Management, highlights a discrepancy within option markets; while monetary stimulus has crushed bond volatility, the VIX is holding above historic averages.

"Central banks can effectively control the level of bond yields, but they can't control the level of equities," Paolini said.

That is significant because government bonds usually act as a safe-haven, rising when equities fall. But with the yields almost fixed, those returns from bonds are minimal, pushing investors to look for money-making opportunities elsewhere.

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Bull and bear, symbols for successful and bad trading are seen in front of the German stock exchange (Deutsche Boerse), as markets react on the coronavirus disease (COVID-19) in Frankfurt, Germany, March 25, 2020. REUTERS/Ralph Orlowski

"The negative correlation between bond and equity volatility makes a huge difference on the risk you can take," he added.

Spiking volatility is not necessarily bad news; violent price moves can be profitable, especially for currency traders.

March ructions helped big FX dealing banks JPMorgan <JPM.N> and Citi <C.N>, report a 68% and 77% rise respectively in fixed income revenues, a category that includes currencies.

Hedge funds made forex-linked returns of 5.1% in the first quarter of 2020, versus a 0.38% loss a year ago, the HFRI Macro Currency Index shows.
WHY SO LOW?

The crisis has not created new worries for financial markets just intensified trends that have been around for the past decade; central bank liquidity, shrinking interest rate gaps and buoyant equities. As for U.S. election risks, strategists say equity options have long priced those.

And years of high and persistent uncertainty levels may be dampening market swings, Barclays analysts said.

The high-uncertainty backdrop is effectively like background noise, causing "inertia and herding behaviour" in markets. But a sudden shift can send volatility gauges soaring, putting investors to flight, the Barclays analysts said.

The effect is "lower average realised volatility with more spikes," they added.

This may be the calm before the storm but NatWest's McCormick points out FX and bond volatility has risen every August for the past seven years.

Those who see VIX futures as a predictor of equity volatility point out the curve usually inverts shortly before risk events, as it did in February. The curve is currently flat but Matt Thompson, managing partner at Thompson Capital Management in Chicago, attributed that to a "muddled" picture.

"Right now, the VIX is having a hard time placing the end of this (coronavirus) thing, and then having the election stuck right in the middle of that," he said.

(Reporting by Olga Cotaga and April Joyner. Writing by Sujata Rao. Editing by Jane Merriman)

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