Understanding Volatility

In this report, we show graphically the dampening impact of central banks and short volatility strategies on financial markets.  While the effects of volatility compression have been clear, we believe the underlying mechanisms by which volatility is generated have not been changed.

Understanding Volatility

> The best long-term predictor of volatility is the credit cycle

Surges in corporate leverage often lead to volatility as the credit cycle matures. The lagged growth in corporate credit, the shape of the yield curve and real lending rates together reliably predict volatility regime shifts.

> The second big structural driver of market volatility is economic volatility

Periods of high market volatility have generally been correlated with periods of high economic volatility. This is true in general, but it is particularly true during recessions when we see large spikes in the VIX and steep drawdowns in financial markets.

> Herding in financial markets predicts crashes

The two best predictors we have found for sharp market corrections or crashes are 1) rising volatility across asset classes at the same time as widening credit spreads, money market and interbank lending rates and 2) herding in financial markets as measured by cross-asset class correlations.

Overview

Central bank suppression of volatility is like trying to prevent forest fires by indiscriminately putting out all fires no matter how small.  Although in the short-run there are no big fires, this often leads to denser trees and debris in many forests, which enables unusually large wildfires to burn.

It is extremely important to point out that low volatility in and of itself is not a problem.  Volatility is serially correlated, and periods of low volatility follow periods of low volatility.  Likewise periods of high volatility follow periods of high volatility.  This is very much like one of the most basic methods of weather prediction.  The rule that tomorrow’s weather will be like today’s is generally right.  It is only wrong when the weather changes.  In this report we outline the tools we use to identify the changing winds of volatility. 

The Variant Perception Framework

Our Head of Research, Tian Yang, recently appeared on Real Vision to outline the framework through which we approach markets and investing.