So Much Uncertainty, So Little Volatility

Equating economic uncertainty with financial market volatility this year would have been a dangerous game.

Perhaps the biggest theme of 2012 for many asset managers was how waves of monetary policy easing from the world's big central banks smothered market volatility - even as everyone frets about slowing growth and earnings, recession and inflation threats, and ongoing sovereign debt and banking nightmares.

To the extent that reducing fears of financial collapse and preventing the world's biggest money managers going to ground was a central aim, then central banks' overwhelming policies of the past year have been remarkably successful.

Almost every measure of market volatility has subsided.

The VIX, or "fear index" of implied one-month volatility for Wall Street equities, for many the global benchmark, has been below 20 percent for nearly six months. At about 16 percent today, it's basically nuzzled into where it was in early 2007 before the credit crisis blew up - if not quite as low as the 10 percent seen in the frothy years up to 2006.

When you compare that to peaks of some 45 percent in mid-2011, or near 90 percent after the Lehman Brothers bust in 2008, you get some picture of how suppressed it has been.

The picture is much the same in Europe, where the three-year-old debt crisis has dragged economies into recession. At 17 percent, the Euro STOXX 50 Volatility index, is about half its levels of a year ago and at its lowest since the credit crisis erupted five years ago.

And it's not just equities. Currency market volatility has evaporated too, with six-month implied rates on the euro/dollar exchange rate at just over 7 percent - also half where it was a year ago and its lowest level of the credit crisis.

Actual market volatility is even lower, with euro stocks volatility at less than 15 percent over the last 30 days and euro/dollar currency volatility at just over 5 percent.

That makes hedging via options, whose prices reflect implied future volatility, look "expensive" versus observed market risk.

'FIRE HOSE' MONETARY POLICY

So how accurate are these measures given the palpable economic uncertainties?

JPMorgan has argued that low market volatility is not wholly inconsistent with low global growth, given a policy-cosseted world in which global economic volatility itself has slumped back again to its lowest since the 1970s after the sharp spike of 2008/2009.

Synchronised money printing in late summer by the U.S. Federal Reserve, Bank of England and Bank of Japan, and the European Central Bank's vow to protect the euro were critical in ramming home the authorities' determination to act.

And volatility remains historically subdued despite all the angst about the U.S. "fiscal cliff" deadline next week.

"Short-term market volatility has been eerily low compared with political uncertainty that is at levels hit during the depths of the financial crisis in 2008," Russ Koesterich, BlackRock's Chief Investment Strategist, said this week.

Policy intervention can be the only culprit, he added. "If financial markets are underwritten, albeit precariously, by central banks and governments, there is no need for asset prices to reflect any worries."

And far from being just a balm for big buy-and-hold investors or conservative pension funds, Societe Generale strategists point out "huge" short-selling by hedge funds and others of VIX contracts on futures and options exchanges.

The Fed scaling up its monetary easing even further this week has also had an impact.

"Net short positions on the VIX are huge at more than five standard deviations below historical averages since 2005," SG said. "Hence, the number one conviction of hedge funds appears to be that the widely anticipated acceleration of the Fed's balance sheet to $85 billion per month is incompatible with an increase in volatility in the near future."

COUNTER-INTUITIVE CONSENSUS

So, as counter-intuitive as low market volatility may appear, it also seems to be fast emerging as a consensus trade.

However, some wonder if central bank attempts to set firm targets and timelines for their extraordinary actions - notably the Fed's a pledge this week not to raise interest rates while the jobless rate remains above 6.5 percent - might be sowing the seeds for a bumpier 2014 and beyond.

To the extent that these explicit targets start a countdown to the end of what Blackrock describes as the "fire hose of monetary liquidity", perhaps markets will start to behave very differently if the economy does show a real strengthening.

The irony then is that any sharp improvement in the underlying economy may over time lead to more market volatility than a further economic deterioration, which everyone now assumes will be met with ever more central bank liquidity.

"Because they've essentially named a strike price of when QE ends, it means you can actually calculate a probability of getting there depending on the data," said Gerry Fowler, BNP Paribas' Global Head of Equity and Derivative Strategy.

"Payrolls days become even more important."

(Editing by Catherine Evans)