The era of low volatility may be nearing a close, with interest rate hikes on the horizon.

“Volatility has been a bit elevated the last week or two,” said Scott Ladner, director of alternative strategies at Horizon Investments. “That’s not limited to the equities markets. Fixed income volatility has also seen a material rise.”

Horizon Investments, an investment advisory firm headquartered in Charlotte, N.C., uses proprietary volatility modeling algorithms to forecast future volatility of a portfolio. It simultaneously calculates a series of trigger levels that will generate signals to reallocate assets based on the value of a portfolio.

“Options markets are steeling themselves for an increase in volatility, at least in fixed income shorter term options,” Ladner said. “That means three and six month options on two and five year rates. We have seen those implied volatilities go up a fair amount since Yellen spoke.”

Fed chair Janet Yellen said in her press conference in March that the central banks is likely to begin raising interest rates as early as six months following the end of quantitative easing this fall, or approximately one year from now.

Hedge funds, which tend to go short volatility, are scrambling to cover their positions

“The speculative positions of hedge funds in VIX futures and VIX futures options has gone to zero,” said Ladner. “Professional volatility traders, especially in equities, are naturally short volatility and we have seen that be covered. That was consistent with the uncertainty of Ukraine. We haven’t seen any evidence of a repositioning on the short side from the equity volatility space.”

In a recent client note, Societe Generale’s Alain Bokobza and Arthur Van Slooten suggested that the period of low volatility is coming to an end,

The absence of net sellers of VIX is remarkable, they wrote. Historically, and in combination with long equity positions elsewhere, hedge funds have a strong natural bias toward net selling the VIX.
With the forward market for VIX still in strong contango (a condition where the expected spot VIX level is lower than the futures level) as it is currently, without a rise of the VIX it costs money to be long and it pays to be short, according to SocGen.

“Somewhat lower levels of volatility recently, combined with a risk of a spike in volatility due to geopolitical tensions with Russia, are likely to have an influence, but alone do not explain the trend,” said Bokobza and Van Slooten. “Hence our conclusion that the period of low volatility is coming to an end.”

Ladner expects volatility will stay muted, at least in equities, for the rest of the year. “We’re seeing incredibly low levels of implied volatility in the currency space, especially in the majors,” he said. “Very low volatility expectations for fixed income as well. When you get big rises in volatility, it tends to affect all asset classes.”

Horizon’s RiskAssist strategy, which Ladner helps to manage, is akin to a managed volatility strategy, but it’s focused on downside volatility rather than overall market volatility. The strategy analyzes portfolio holdings daily and provides objective criteria to reallocate a portion of the portfolio to a fixed-income basket.

“In 2013, we just got market returns for that strategy,” said Ladner. “As far as our view on volatility, we have different types of models that project future volatility, and that impacts some of the hedging decisions we make in RiskAssist, but we aren’t seeing any material uptick in any of those metrics at this time.”

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