"Volatility Is Lowest Since the Great Depression"

Here's my take on why the market has such low expectations for volatility...

#1. We know that volatility tends to carry a lot of momentum with it, and also, is in general negatively correlated with equity prices, so that equities tend to go up more gently than they go down.

#2. We know that central banks are very heavily involved in markets in recent years, and are watching equity prices closely.

Thus, it seems as though investors are generally just being chased into equities by central bankers, and that there is little probability of the equities going in either direction very far without the Fed moving to counteract that move.

In other words, the Fed has effectively put the stock market on training wheels. If stocks drop too low, then the Fed will simply find a way to take more emergency stimulative measures to chase money back into equities. If stocks rise too high, then the Fed will have greater leeway to start dialing back its current stimulative measures, and this should cause the equity markets to fall back down a notch.



Okay, now here's why I think that the market has been lulled into a false complacency:

#1. Historically speaking, this is just too low, and I think that is an argument unto itself.

#2. Much like the late 1960s, there seems to be a lack of appreciation for how much instability is lurking in international markets. We are seeing people start to complain about foreign exchange policy for various currencies, and central bankers in developed countries like China and Mexico are starting to worry about shocks from somewhat hot money flooding into their economies from relative currency devaluation from the more developed economies. In sum, the super low inflation we've experienced cannot last, (A) because rises in asset prices will eventually put upward pressure on consumer prices, and (B) because capital flows going to less developed economies are somewhat ephemeral, and will eventually boomerang back into more developed economies.

If this occurs in similar fashion to 1997 & 1998, then the dollar might become super strong again relative to other currencies, but this in turn might create an overheating problem that will require the inevitable painful rise in domestic interest rates. At that point, the volatility we've been missing should hopefully FINALLY return.



Now, as with so much else since the financial crisis of 2008, there are a lot of macroeconomic corrections and other things that must happen, but that are being put off indefinitely by extraordinary policy remedies. There seems no limit to how far this transitory period can go on, and every time so far when I thought that things have to get back to normal soon, the abnormal time period has just continued to keep going.

So don't hold your breath waiting for it to end--and for the remainder of this year, it might even keep going lower--but at the same time, know that it must end eventually.

I appreciate this thread.