Low Volatility Offers And Opportunity To Hedge Risk

Traders look at screen at the Buenos Aires Stock Exchange on June 18, 2018. – The Buenos Aires Stock … [+] Exchange plunged 6.55 percent Monday, pulled down by sharp declines in prices for energy and bank shares and amid market volatility as Argentina seeks financial support from the IMF. (Photo by EITAN ABRAMOVICH / AFP) (Photo credit should read EITAN ABRAMOVICH/AFP via Getty Images)

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Only a month on from the beginning of the invasion of Ukraine, equity volatility (as measured by the Vix volatility index) has dropped significantly below the 20 level. Typically this is a positive sign and many traders use a low volatility environment to put cash to work. At the same time it suggests a degree of complacency and an increasingly odd environment where equity markets again (following the coronavirus pandemic) appear to be discounting human misery.

Bond volatility

What is also puzzling is that volatility in the bond market (see the MOVE index) is at extreme levels, as both short term and long bonds sell off with expectations of rising inflation and interest rates. Indeed, the difference between equity and bond volatility is pronounced and suggests that one will catch up with the other.

My sense is that equity volatility will rise in coming days. Whilst equity markets have likely put in an invasion related ‘bottom’ equities no longer seem to price in tail risks from the situation in Ukraine, nor a prolonged conflict that would produce a recession in Europe. Neither do they seem to discount a further disruption to supply chains from a growing coronavirus crisis in China.


Add to this a range of technical, flow and risk appetite indicators look stretched to the upside. In this context, only a credible end to the invasion of Ukraine could in my view push markets higher into ‘melt-up’ territory.

In the background, the risk is that the Federal Reserve and other central banks continue to (over) react to high inflation figures, having under-reacted last year and that bond prices break downwards from their historic ranges.

In this context, low equity volatility offers a hedging opportunity, rather than a chance to take on more risk. Many investors end up buying protection at expensive levels, but volatility is now getting into cheap territory and should be taken advantage of.

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