The global economy continues to struggle with sluggish growth. Trade frictions have not erupted, but nor have they been resolved. Iran just seized a British tanker and BlackRock’s Global Index of geopolitical risk just hit an all-time high (see Chart 1).
The reaction by investors? Drive volatility down to a three-month low.
While recent behavior could easily be interpreted as complacency, there is another explanation. Central bank liquidity — and the promise of more — is dampening volatility, as it has for most of the past decade. More importantly, this can continue.
Back in May, when volatility briefly spiked, I suggested that easing financial conditions would mitigate any rise in equity volatility. Since the peak in early May, the VIX Index has fallen about 40%. Going forward, while volatility can spike with headlines, tweets and shocks, the pivot towards easier money is having the desired effect.
Easy money, lower volatility
My working framework is the same as the one I described back in May: Slower growth will nudge volatility higher, but easier financial conditions will counteract much of the increase. To be clear, weaker growth has historically been associated with higher equity volatility. Using my favorite leading indicator, the Chicago Fed National Activity Index (CFNAI), when the CFNAI is above 0 the VIX averages between 16 and 17. In periods when the indicator is below 0, suggesting softer growth, the average VIX reading is 21.
Today, with growth sluggish and the CFNAI three-month average below 0, you would expect higher than average volatility. Instead, the VIX is trading in the low-teens, well below its historical average of around 20. What accounts for the discrepancy? Financial conditions.
Financial conditions were already easing in May. Since then they have eased further. Some manifestations of this trend include a 40 basis point (bps, or 0.40 percentage points) drop in long-term bond yields, a 50 bps plunge in two-year interest rates, and a slightly softer dollar. While not all measures of financial conditions have eased – high yield spreads are a bit wider– most indicators suggest easier and cheaper financing. Given a likely trim in rates from the Federal Reserve and more aggressive easing from the European Central Bank (ECB), investors can reasonably expect more of the same in the second half of the year.
This is critical as broad measures of financial conditions are the best coincident predictor of equity market volatility. For example, a simple two-factor model including a broad measure of financial conditions by the St. Louis Fed, combined with high yield spreads explains nearly 80% of the variation in the VIX. Today, the model suggests that volatility in the low-teens is close to fair value.
The bottom line
Absent a sizeable shock, one with the potential to seriously slow the global economy, slower growth is being offset by easy money. Once again, central banks have investors’ backs.