Unusually calm markets in foreign exchange and other assets face a period of turbulence as a sharp fall in the cost of short-term insurance signals investors may be too optimistic on the global economy.
Short-end implied volatility — a measure of financial market risk and a key factor in calculating option prices — for major currencies has fallen to levels last seen before the collapse of Lehman Brothers in 2008, largely led by rising stock markets and falling global risk aversion.
One-year volatility, however, has not been falling as much, reflecting strong demand from investors to hedge against volatile long-term moves as concerns persist over the impact of interest rate rises and the risk of inflation.
This is making volatility curves unusually steep. The current level of steepness in dollar/yen and euro/dollar is above the 80th percentile of Goldman Sachs's observations over 10 years. This means the curve has been as steep as this only for 20 percent of the past decade.
This unusual phenomenon has dual implications for investors. Short-end vols may have fallen too much, indicating a correction may be on the cards as investors scale back their optimism.
On the other hand, their long-term concerns might ease as the path of interest rate rises becomes clear, leading to a flatter and more normal volatility curve.
"As far as equity markets are concerned, it's a walk in the park. It would be very hard for FX options to rise in the front to 3 months," said Simon Smollett, options strategist at Credit Agricole CIB.
"That's why you are seeing this gradient in the FX market. We're in the doldrums but everyone knows this is the calm before the storm."
One-month implied volatility in euro/dollar stands at 9.57 percent, not far from a 19-month low set in March, compared with one-year volatility of 11.5 percent. The spread of around 1.9 points, compared with around 0.7 in early February.
"Big macro players do not trust the current trend of steady growth. There is a belief that the entire recovery is based on the prop of quantitative easing. When this crutch is taken away the global economy will fall," said Mark Johnson, managing partner of FX hedge fund Johnson Stewart Partners.
"I am agnostic on this front...QE may only be removed at a very gradual pace and the sudden jolt may not happen. It is expensive to be long options with any significant duration."
The collapse in short-end vols is driven by the Volatility Index — often called the fear index, which measures the implied vol of the S&P 500 index. It hit a 33-month low below 16 percent on Monday.
Volatility curves in the S&P 500, FTSE, oil and 10-year European rates are also steep, staying above the 90th percentile of Goldman's 10-year observations.
Goldman says the S&P index in particular has seen the spread between implied volatility at the 2-year and 3-month horizons has topped 3.5 points, among its widest levels in more than five years.
"(There are) a host of uncertainties concerning the forward path of data and policy, including more extreme scenarios such as the possibility of double-dip recessions, high inflation and so on — that are keeping longer dated volatility at high levels," Goldman said in a note to clients.
Danske Bank, which analyzed volatility spreads, found that implied volatility — which by its nature is higher than actual volatility — tends to correct if it falls below the actuals.
"It seems markets are getting caught wrong-footed again and again," said Sverre Holbek, Danske's senior analyst.
"Of course the risk is we see some setback and the short end should head higher. It would probably also take a prolonged period of rising risk appetite to calm the long end."
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