Markets for equities, bonds and currencies are the calmest they've been since 2007, and that's making some investors nervous.
Options that protect against S&P 500 losses plunged 64% in the last two quarters — the most ever — data compiled by Bloomberg show. Interest rate volatility is near a five-year low, while demand for hedges against extreme moves in the dollar is close to the weakest since 2008. Bank of America Corp.'s Market Risk cross-asset volatility index reached a level not seen since November 2007.
Becalmed markets have fooled investors before. The Chicago Board Options Exchange Volatility Index fell to a 13-year low of 9.89 in January 2007 before the financial crisis of 2008 wiped $37 trillion from share prices worldwide. As the gauge of options prices slipped to within five points of that level last week following a 28% S&P 500 rally, demand has risen fivefold for exchange-traded products whose value increases when volatility rebounds.
“Nobody is scared right now, but the fear will come back,” said Sean Heron, who manages options strategies at The Glenmede Trust Co. NA, which oversees about $20 billion. “All bets are off as soon as we get beyond the next three months. Europe could rear its ugly head again and it's an election year in the U.S.”
FINANCIAL STRESS
Bank of America Merrill Lynch's indicator of cross-asset volatility, a component of its Global Financial Stress Index, fell to -0.41 on March 29, down from 0.28 at the beginning of the year. It touched -0.48 on March 2, its lowest level since November 2007, just before the U.S. economy entered an 18-month recession and a month after the S&P 500 reached a record high.
The index is a measure of future price swings implied by options markets in global equities, interest rates, currencies and commodities. A negative number means lower-than-normal volatility expectations based on data going back to 2000.
“The rally in risk assets, combined with the liquidity support provided to the market by central banks, have acted to depress volatility,” said Benjamin Bowler, San Francisco-based head of global equity derivatives research at Bank of America Corp. “If the recent strength of the U.S. economy begins to fade and markets roll over, then I would expect to see a rise in volatility.”
The VIX averaged 18.04 from January through April 2011, falling to 14.62 on April 28, a day before the S&P 500 peaked and began a 19% decline that lasted until Oct. 3. The S&P 500 moved 1.3% a day from April through December, compared with a 50-year average of 0.6% before the collapse of Lehman Brothers Holdings Inc. in 2008.
LIQUIDITY INJECTIONS
Investors have been appeased so far in 2012 as central banks from Europe to the U.S. and Asia try to speed the recovery from the first global recession since World War II. The Federal Reserve pledged to keep rates near zero through at least late 2014, while the European Central Bank gave banks more than $1 trillion of three-year loans. The Bank of Japan unexpectedly added 10 trillion yen ($120 billion) to an asset purchase program in February.
Improvements in U.S. payrolls and consumer confidence pushed the S&P 500 to its biggest first-quarter rally since 1998. It advanced 12% in 2012 to 1,408.47 on March 30. The VIX slid a record 66% since its Oct. 3 high to 15.5 on March 30, below its 22-year historical average of 20.54. The gauge, which touched its lowest level since June 2007 on March 26, gained 0.9% to 15.64 in New York on April 2. Meanwhile, Europe's VStoxx Index fell 5.9% to 21.22.
VIX'S AVERAGE
“The current equity volatility environment is supremely challenging,” Jeremy Wien, head of VIX trading at JPMorgan Chase & Co., wrote in a March 30 e-mail. “Do we buy volatility at low levels relative to the last few years because of the headline risks or do we sell volatility because the market is hardly moving?”
Investors have piled into exchange-traded products, betting that the volatility decline won't last. The number of shares outstanding for 17 such products that increase when the VIX rises has jumped more than fivefold this year, according to data compiled by Bloomberg.
Shares of Barclays PLC's iPath S&P 500 VIX Short-Term Futures ETN, the largest ETP that climbs when the VIX increases, jumped fivefold this year to a record 114.3 million March 23, boosting its market value to as much as $2.18 billion March 19. The price of the note is down 53% this year.
TVIX
Demand for Credit Suisse Group AG's VelocityShares Daily 2x VIX Short Term ETN, known by its ticker symbol TVIX, pushed shares outstanding to 54.2 million, up almost elevenfold since the end of last year. The bank stopped issuing shares Feb. 21 “due to internal limits on the size of the ETNs,” according to a statement at the time.
The market capitalization of the note reached almost $700 million March 6. The TVIX, which has lost 77% this year, aims to generate twice the daily return of an index tracking VIX futures.
Swings in Treasury yields have been subdued as the Fed's pledge to keep borrowing costs low anchored short-term rates and concern about a European sovereign-debt crisis have made in-vestors reluctant to sell U.S. debt. The 10-year Treasury yield moved between 1.79% and 2.16% in the four-month period ended Feb. 28.
Bank of America Merrill Lynch's Move Index, which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, fell to 69.9 basis points March 12, the lowest since July 2007.
QUANTITATIVE EASING
“The potential for more quantitative easing has grown [recently],” said Brian Svendahl, Minneapolis-based senior portfolio manager of fixed income at RBC Global Asset Management Inc.
His firm oversees more than $250 billion in assets. “We are likely a few data points away — or even a European explosion away — from more monetary accommodation.”
Wall Street's largest bond-trading firms think the worst is likely over for the Treasury market as the pace of economic activity wanes amid U.S. budget cuts and $100-a-barrel oil. After reaching as high as 2.4%, the 10-year Treasury note yield ended the quarter at 2.21%.
The yield on the benchmark 10-year note will finish 2012 at 2.48%, according to the median estimate in a Bloomberg News survey of the 21 primary dealers that trade with the Federal Reserve.
EXTREME CURRENCY MOVES
A gauge of the demand for hedges against extreme currency moves in the dollar against the euro, known as the option butterfly, is near a low touched in March 2011, which was the lowest since September 2008, before the collapse of Lehman Brothers.
