Global political uncertainty has rarely been higher in recent memory. Brexit, North Korea, upcoming Italian elections, and fresh concerns about a possible Trump impeachment loom, and a major geopolitical event seems increasingly possible. And yet implied volatility has rarely been lower, whether for equities, interest rates, currencies, or commodities. One measure of implied volatility, the VIX, closed below 10 on May 8, something that has happened only nine times since 1990.
Importantly, it is not just implied volatility that is so low. Realized volatility has also been remarkably dormant. Indeed, over the past twelve months, the rolling thirty-day realized volatility on the S&P 500 has averaged a paltry 9.4.
Why have realized and implied volatility been so low, despite the plethora of known risks? Market pundits have suggested a number of possible explanations: the rise of volatility-selling ETFs, short gamma positions among broker-dealers, and the shift from active to passive investment management. Recently, Mark Mobius of Templeton Advisors even suggested that social media and the spread of fake news could be to blame. By his telling, the glut of confusing headlines is causing people to dismiss new information, because they can no longer be sure what is true.
While each of these suggestions has some merit, the true explanation is likely far simpler. Just as the nature of water changes when the temperature drops below zero degrees Celsius, so too does the nature of financial markets when real interest rates become negative. Put simply, when central banks push real rates below zero, financial volatility freezes.
The chart shown here plots a smoothed average of the VIX index against a lagged measure of the real federal funds rate. The image is highly suggestive. In short, volatility appears to react to changes in real interest rates with a lag of one to two years years. When real interest rates are high, so too will be financial market volatility. And when real interest rates are lowered, financial volatility will likewise be suppressed.
Why might volatility show such a strong relationship with changes in interest rates? In a 2006 paper, Raghuram Rajan, former governor of the Reserve Bank of India and now a professor at the University of Chicago, suggested that low policy rates might induce procyclical risk-taking in financial markets. He highlights the incentives of insurance companies with fixed-rate commitments as...