After years of low volatility, the market is being dragged kicking and screaming back to reality.
The return of volatility in equity markets was a sharp and necessary reminder that markets have been induced into a comatose state since the loosening of monetary policy in response to the financial crash. The availability of cheap credit allowed equity markets to swell enormously, and it appears that investors had become complacent in the face of lax conditions. However, the news that US wages had increased by 2.9%, the highest year-on-year increase since 2008, has brought the market down into the real world – where credit is not always cheap and stable conditions not guaranteed.
While substantial wage increases may appear long overdue, they have serious implications for financial markets. Wage increases are usually followed by increases in inflation, which from the perspective of a central bank is a welcome return. Quantitative Easing programmes along with interest rates at the zero-lower bound were designed to curb the risk of deflationary pressures which loomed large just two years ago, and this objective has finally been realised. As such the radical programmes can finally be unwound, but this will drastically change the financial landscape which has adjusted to the loose-money conditions. Bond yields shot upwards in response to higher inflation expectations, and the price of the bonds simultaneously plummeted as bond prices move inversely with yields. It is expected that interest rates will continue to increase this year, and as such vast amounts of cash was withdrawn from equity markets and moved towards the bond markets which seem to promise increasing returns. At the trough, global stock losses exceeded $5tn according to S&P Dow Jones Indices.
However, interest rates alone were not solely responsible for the dramatic week in trading. The Vix Index has come under heavy scrutiny in light of the volatility, and its impact in exacerbating the situation is disputable. Also known as Wall Street’s ‘fear gauge’ the index measures volatility in the market, and an extensive market of Exchange Traded Products (ETPs) have emerged for trading volatility, powered by a multitude of algorithmic trading strategies. After years of minimal volatility, future trading of volatility had been largely based around shorting – meaning that investors receive a pay out when volatility remains low. When the index unexpectedly recorded the greatest percentage jump on record, vast losses were therefore recorded by those shorting volatility. After an extended period lying below the long-term average score of 20, the index shot above 50 for only the second time since 2010. Such a dramatic change caused two major ETPs to collapse – one of these products had previously been valued at $2.2bn.
However, the collapse of these products was not the only casualty of increased volatility. The development of complex algorithmic trading strategies has many benefits, but in this instance, it only served to intensify the rapid selloff of stocks. It may seem logical for such algorithms to be linked to the Vix Index – as volatility starts to increase stocks will be automatically sold off to avoid massive losses on investments if the value of the stock were to suddenly decline. However, if many strategies are organised in this way then it only serves to worsen the volatility that investors seek to avoid. External shocks to the market such as an increase in inflation expectations will cause a spike in volatility, triggering an uncontrollable snowball effect of selling, driving down prices and increasing volatility further.
It is impossible to attribute responsibility for the shock to any individual factor, although tremors have nonetheless rippled around the financial world. While the comfortable response is to view this as a one-off peculiarity caused by the Vix Index, the likelihood is that we are returning to pre-crash economic conditions which are less forgiving and require more thoughtful investment. Gone are the days when you can pump cheap credit into stocks, or short volatility for a guaranteed profit. It may hurt at first, but its long overdue.