Weirdly Calm

My last post (of about three hours ago) got me wondering why the VIX is actually so low right now. It hardly seems like the global economy should be at its most stable in thirteen years, but one possible explanation appeared in my Twitter timeline linking to an article in the New York Times :

The Stock Market Is Weirdly Calm. Here’s a Theory of Why by Neil Irwin

When Donald J. Trump won the presidency in November, one bet seemed like a sure thing: We were in for a volatile few years. And in Washington, that forecast has come true. This unconventional presidency is creating an avalanche of uncertainty in areas including global trade, taxes and health care.

But on Wall Street, these are the quietest of times. Prices for stocks and many other assets are less volatile than at any time since before the global financial crisis a decade ago, and volatility is, by some measures, near record lows.

Consider this: In 2015, the Standard & Poor’s 500 index moved by more than 1 percent on 29 percent of trading days. Last year that fell to 19 percent. So far in 2017, there has been a 1 percent or greater swing in the market in only three trading sessions, or 3.5 percent.

And the Volatility Index, or Vix, which captures expectations for future stock market volatility based on prices in the options market, finished Monday at the lowest level in its 27-year history other than three days in December 1993.

This sense of calm would be notable in any event, but the contrast with the sheer variance in the policy world makes it particularly unusual. In a single week, the Trump administration might flirt with exiting the North American Free Trade Agreement, roll out an outline for a multi-trillion dollar tax cut and push legislation that would overhaul the health care sector, one-sixth of the United States economy.

There are some technical explanations for what is going on. The advent of products that let people easily bet on the Vix and other volatility indexes may be distorting their prices, and there have been changes in how major investors are hedging their portfolios against losses that may be making the index artificially low.

But while they do a good job of indicating why indexes like the Vix are so low, these technical explanations are less effective at explaining why the actual fluctuations in markets have been so subdued — realized volatility, to use the traders’ term, as opposed to expected volatility.

Something is causing the shares of the most widely owned companies to jump around less than they almost always have in the past. And they also don’t do a great job of explaining why many other markets have also become less volatile than in the recent past, including international stocks, currencies and bonds.

Dating to the 2008 financial crisis, markets have swung on every hint of news out of world capitals — Washington, especially, but also Berlin and Tokyo and Beijing — because the very future of the global economy seemed to hang in the balance. From the financial crisis to the eurozone crisis to the efforts by Japan to reflate its economy to the effort by China to de-leverage its economy, the policies set by central banks and national governments were the prime mover of investor sentiment and the global outlook.

Rarely have stock prices been as stable as they have been in 2017, according to a commonly used measure of expected stock market volatility.

Those days are over, at least for the moment. In normal times, markets are driven much less by what governments do and much more by, well, the economic fundamentals. How many people are working, with what level of productivity and savings levels, and what are the resulting economic growth rates, levels of corporate profitability, and interest rates?

Even though it is a historical aberration, doesn’t the very low stock market volatility of 2017 make more sense than the kind of wild swings we saw until recently? Why should the collective value of major companies swing by more than 1 percent three days out of 10?

After all, the assets of those major companies — Exxon Mobil’s oil rigs and Google’s search algorithm and all the rest — don’t really change from day to day. All that changes is investor perception about what kind of cash those assets will generate in the future. Isn’t it actually fairly rare that a piece of news should change the fundamental outlook by that much?

What makes this moment unusual is that there really are policy choices in play that could have hugely distortive effects on those fundamentals: what happens to trade policy, taxes and health care in the United States; what terms Britain achieves in its exit from the European Union; even whether the E.U. as we know it survives.

But if the last few years have taught investors anything, it is that those with a hair-trigger reaction to political news stand to lose, while those who bet on a continued steady and unexceptional expansion will win.

You see a bit of that in how subsequent conflicts over United States fiscal policy during the Obama years generated less market volatility. The debt ceiling standoff of 2011 generated huge market swings as traders bet on the risk of a default; the standoffs over the “fiscal cliff” at the end of 2012 and a government shutdown in October 2013 caused mere murmurs.

Investors learned a lesson that it’s easy to overreact to political developments, and the same seems to have happened globally in the last several months.

The risk, of course, is that this generates complacency.

Low volatility could make banks, hedge funds and other institutions more comfortable taking on extra leverage, paradoxically making the financial system less stable and more subject to large swings over time.

And perhaps most worrisome, sometimes big financial market moves are the mechanism by which policy makers receive the signal that they’re doing the wrong thing. We saw that again and again in the global financial crisis and the eurozone crisis, when it was big market swings that got governments’ attention.

So the biggest risk of this period of ultra-low volatility is that by looking past the latest headlines out of world capitals, investors won’t send the signals that might prevent political leaders from making a mistake in the first place.

Political leaders make mistakes? Who knew?