Low Volatility, Rate Risk Vex Markets

Terry Flanagan

At mid-year, market participants are keenly watching two metrics: the CBOE Volatility Index (VIX), and the yield on the benchmark 10-year U.S. Treasury note.

The former has declined this year from oddly low to still lower, underscoring a troubling quietness in the markets. The latter has also ratcheted downward from already-low levels, continuing to stave off widespread predictions of an inevitable and substantial ascent.

“Be prepared to be surprised” by the market at some point this year, one executive at a leading proprietary-trading firm told Markets Media.

This person cited “going from a low volatility environment to an even lower one” and “market complacency” as the biggest surprises thus far in 2014. The main themes at the trading firm have been “diversification and control,” the person added.

The VIX spiked 1.4, or more than 10%, to about 13 on July 10, amid signs of financial stress in Portugal and turmoil in the Middle East. The so-called fear index had been languidly moving about 0.25 per day if that, and it remains quite low by historical standards.

“How do volatility traders make money in today’s environment?” one executive at an alternative-investment firm asked rhetorically. “It was like this from around 2003 to 2007, so it could be for a good long time.”

The 10-year yield was most recently at 2.5%, down from close to 3% at the beginning of this year. Many market participants and observers expect that yield to rise closer to historical norms of 4%, 5% or higher at some point, perhaps rapidly and causing some market dislocation. In the meantime, institutional fixed-income investors remain challenged to make up for the yield shortfall somehow, in some way.

“There is interest-rate risk for these giant money managers,” said an executive at a large U.S. exchange operator. “There are risks in fixed income markets, but there are also opportunities, for example in infrastructure and in option writing.”

Concern about higher interest rates has boosted demand for nontraditional bond funds including so-called ‘40 Act’ liquid alternative funds, said the alt-investment executive. “There is a big interest in this space because people are scared of rising rates,” he said.

Featured image via iStock

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