The CBOE Volatility Index (“VIX Index”) and the Merrill Lynch Option Volatility Index (“MOVE Index”) are both hovering near their all-time lows. The VIX Index measures volatility in the equity markets, while the MOVE Index measures volatility in the Treasury markets. Despite the headlines, both indices hit all-time lows in July and remain about twenty percent below their five year averages. Declining volatility has gone hand-in-hand with rising equity valuations and lower yields and credit spreads. Understanding the reasons for declining volatility may be useful in forecasting where valuations are headed in the future.
It is important to recognize that declining market volatility has coincided with lower economic volatility. Economic cycles have lengthened, even though the trend growth rate has fallen domestically over the last few decades. Manufacturing has become a smaller and smaller part of the economy over time, while the importance of services such as healthcare and education has risen. The service sector as a whole is a lot less cyclical than the manufacturing sector and a lot less swayed by inventory cycles. As the slower-growing, but steady service sector has risen in importance, economic cycles have elongated, even if the average growth rate has slowed. This has undoubtedly contributed to a steadier economy and likely put downward pressure on market volatility as the U.S. economy has become more predictable.
During the last decade, the Federal Reserve along with other central banks bought trillions of dollars of bonds and in some cases equities. This created a consistent bid in markets. While the Federal Reserve is expected to begin shrinking its balance sheet shortly, the rest of the developed markets' central banks are still expanding theirs. This constant accumulation of assets has almost assuredly reduced market volatility.
NPP thinks the heightened regulatory environment following the financial crisis had mixed effects on market volatility. On the one hand, improved capital levels at the major banks likely made the economy safer. On the other hand, banks reduced proprietary trading and market making activities which led to reduced liquidity in securities markets. Additionally, the increased regulatory environment dampened new business starts and lessened economic dynamism. The 1990s saw much faster growth and better financial markets, but this happened in the backdrop of more volatility.
The secular shift from a manufacturing economy to a service sector economy has almost certainly led to lower volatility and this trend is likely to continue. Markets are more volatile in recessions, and prior recessions were largely caused by inventory cycles. As manufacturing has faded in importance, the duration of economic expansions has lengthened. In addition, central bank purchases have likely diminished market volatility. Central bank purchases are set to continue abroad, but cannot proceed forever. Finally, the effect of regulatory changes and other factors on volatility are harder to determine, but they have likely dampened volatility as well. In sum, part of the shift is structural: service economies are inherently less volatile than manufacturing economies. The rest of the shift is likely temporary, even if in this case the temporary period has lasted longer than most investors would have expected.