BNY Mellon: Downward Pressure On Realized Volatility
BNY Mellon: Downward Pressure On Realized Volatility
By Simon Derrick, Chief Currency Strategist
- Downward pressure on realized volatility in a range of assets is building as the Fed "put" reasserts itself
- USD/JPY has provided an early indicator of the strength of the put
- A risk of a reach for yield is emerging
While significant cross-currents remain within global markets at present (such as Brexit and Venezuela), a deeper pattern has begun to emerge: realized volatility in a range of key instruments has been heading steadily lower since January 4.
As good an example of this as any is 21-day realized volatility in front month Brent crude futures, which has declined from a post-March 2016 high of almost 45% on January 4 to just over 26% by yesterday morning. This left it just a percentage point above the 10-year average reading.To put this into context, this comes despite the descent of Venezuela - which until recently was the seventh largest exporter in OPEC - into crisis.
Similarly, 21-day realized volatility for the S&P 500 has fallen from a post-2011 high of over 22% to under 11% (again, just a whisker over the 10-year average) despite continued uncertainty over the trade negotiations with China as well as the threat of a resumption of the US government shutdown.
It was already apparent by mid-December that something unusual was going on with realized volatility in USD/JPY (see chart below).
While realized volatility in oil and equity indices had risen to multi-year highs through December, it was declining in USD/JPY.
By December 17 the 21-day reading had fallen back to the October lows, levels only materially breached to the downside on three occasions in the past two decades.
It was already apparent by mid-December that something unusual was going on with realized volatility in USD/JPY
This was notable given that post-2004 (the point at which Tokyo stopped intervening on a regular basis in the FX market) volatility in USD/JPY and the S&P 500 had tended to correlate highly at market extremes.
However, even the spike generated by the USD’s flash crash on January 3 barely managed to take the reading over its 10-year average. By yesterday the reading was rapidly moving back to the December lows.
Some sense of what had driven this sanguine response comes from noting that the clearest declines in realized volatility in USD/JPY came as indications of the Fed "put" emerged post-November 15 and then again from early January onward.
There appears a good possibility that this downward pressure on realized volatility will continue to be exerted
Given the apparent strength of the current put (based upon the performance of USD/JPY) and the experience of the past two decades there appears a good possibility that this downward pressure on realized volatility will continue to be exerted in the weeks ahead.
Why does this matter?
Rather than steadily factor in risks over time, the threat from a reach for yield is that markets tend to remain unresponsive to risks until the very last minute, at which point they react in a highly disruptive fashion (as has been seen on a number of occasions in the past four years).
The concern must therefore be that the latest burst of market calming measures encourages blindness to risk at a time when there remain a significant number of potential threats.