Central Banks Contain Future Volatility in Some Markets, Not All

By Erik Norland

Nearly one year into the pandemic, market participants have grown accustomed to reduced activity across most major economies, governments running large fiscal deficits, and central banks easing monetary policy to overcome weak growth. Amid these economic changes, implied volatility in some markets, notably short-term interest rates, credit markets and currencies, have returned to pre-pandemic levels. Others, notably those on long-term rates, equities, crude oil as well as precious and base metals, remain significantly above levels that prevailed before the pandemic. The underlying theme is that central banks have succeeded in reducing implied volatility in the areas over which they have the most control.

Where the Fed and Its Counterparts are in Command

By and large, central banks have control over near-term interest rates, and in the decade since the global financial crisis they have shown themselves to be adept at managing future short-term rate expectations.  Fed fund futures show that, for the moment, hardly anyone expects the Fed to change rates in the next two years, although the market does price a small probability that the Fed might cut rates (Figure 1).

Figure 1: Fed funds show little likelihood of a Fed rate move in the next two years

In this context, perhaps it’s not surprising that implied volatility on 2Y and 5Y U.S. Treasury options has fallen to historic lows (Figure 2).  Implied volatility on 10Y U.S. Treasury futures (which usually has seven-year bonds as the cheapest-to-deliver) has also fallen to record lows.

Figure 2: 2Y and 5Y bond options volatility has never been so cheap

The exception in the bond market is longer-dated Treasuries (Figure 3).  Implied volatility on long-term bond futures has not returned to pre-pandemic lows.  Long-term Treasury issuance has tripled in the aftermath of the pandemic from $17 billion to $51 billion per month, on average (Figure 4). While central bank balance sheets have soared in size (Figure 5), much of their buying focuses on shorter and medium-term maturity bonds.

Figure 3: 30Y bond volatility remains above pre-pandemic levels

Figure 4: Long-bond issuance has tripled, a bigger % increase than elsewhere on the curve

Figure 5: QE may dampen volatility more on short-term than on long-dated bonds

While central bank buying has not returned implied volatility on long-term bonds to record lows, Fed buying of corporate-bond exchange traded funds (ETFs) has returned credit spreads, such as those on the Credit Suisse High Yield Bond Index, towards pre-pandemic levels.  High yield bonds are not usually thought of as options but their payoff is akin to that of the U.S. Treasury + a short put option on the issuing company (Figure 6).

Figure 6: Fed ETF buying has contained credit spreads to narrow levels despite economic stress

Early in the pandemic, the currency markets were briefly perturbed by dollar-funding issues. In March, the U.S. dollar began soaring until central banks expanded swap lines and provided abundant liquidity.  Since then, implied volatility on many currency pairs has come back to normal levels including EURUSD, JPYUSD and CHFUSD (Figure 7 and 8).  There are some exceptions:  implied volatility on GBPUSD options remains elevated as Brexit deadlines near, while AUDUSD and CADUSD options also remain somewhat more expensive than during pre-pandemic times, perhaps owing to uncertainties over demand for key commodity exports from those Australia and Canada (Figure 9).

Figure 7: CHFUSD and JPYUSD implied volatility is back to near record lows

Figure 8: EURUSD implied volatility is back to near record lows but Brexit still bothers GBPUSD

Figure 9: AUD and CAD implied volatility may be elevated by commodity prices

Where Central Banks Policies Have Not Returned Implied Volatility to Pre-Pandemic Levels

With central banks watching over corporate bond markets, investors don’t seem too worried about the debt side of the corporate ledger.  Where they are more concerned, however, is on the equity side of the equation.  Implied volatility on S&P 500® and Nasdaq 100 options, for example, is way down from its March highs but at-the-money (ATM) options on both indices remain significantly more expensive than they were prior to the pandemic (Figure 10). This is to be expected given that the markets are trading at high multiples to earnings and GDP.  Such multiples tend to vary inversely with long-term interest rates (Figure 11).  The valuation of the equity markets may depend on long-term interest rates remaining low amid record-breaking budget deficits and massive quantitative easing programs.

Figure 10: S&P 500 and Nasdaq 100 implied volatility remains above pre-pandemic levels

Figure 11: Equity market’s high valuations may depend on long-term yields staying low

Indeed, among the equity indices, the Nasdaq 100 has some of the highest valuation ratios and, along with gold and silver, also seemed to benefit the most from the Fed’s $3 trillion of quantitative easing which occurred between March and May (Figure 12).  Since the Fed slowed its QE programs by 97.5% to $25 billion per month, Nasdaq, gold and silver prices began to move sideways starting in August and September.  While implied volatility has come down on all three assets, it remains high by historical standards (Figures 10 and 13).

Figure 12: Fed’s large March-May QE may have driven metals and tech stocks higher

Figure 13: Gold and silver investors await further direction from fiscal and monetary policies

Bottom Line

• Central banks have contained volatility in short-term rates and currency markets
• Fed buying of corporate-bond ETFs has also contained credit spreads
• Monetary policy has been less successful at containing implied volatility in equities, long term bonds and precious metals

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