Four weeks ago I gave the keynote talk at Energy Risk Asia in Singapore. My talk was a look back at commodity market developments in the past year, followed by a look forward.
The theme of the look back was “A Perfect Calm.” I noted that volatility levels across all markets, not just commodities, were at very low levels. Equity vols, as measured by the VIX, had been in the 10 percent range in August and had only ticked up to around 12 percent by late-September. Commodity volatilities were even more remarkable. Historically, the low level of commodity volatilities (the 5th percentile) have been around the median of equity vols and well above currency and bond vols. During the first half of the year, however, commodity vols were below the 5th percentile of equity vols, and below the 95th percentile of currency and bond vols. Pretty amazing.
I argued that this reflected a happy combination of supply and demand factors. In energy and ags in particular, abundant supplies put a drag on volatility. But volatility from the demand side was low too. The low VIX levels are a good proxy for macro uncertainty, or the lack thereof. Put both of those together, and you get a perfect calm.
But perfect calms are the exception, rather than the rule. The last slide in my talk looked forward, and cribbed a movie cliche: It was titled “It’s Quiet Out There. Too Quiet.” I noted that periods of very low volatility frequently bear the seeds of their destruction. When risk measures are low, firms and traders lever up and increase position sizes. A bit of economic turbulence increases volatilities, which leads to breaches in risk limits, which forces deleveraging and reductions in positions. This tends to lead to reduced liquidity, exaggerated price moves, yet higher volatility, leading to more deleveraging and repositioning, and on it goes. That is, there can be a positive feedback loop. Transitions from low to high volatility can be very abrupt.
It looks like that’s what has happened in the weeks since my return. Equity markets are down substantially. Commodities, notably energy, have slumped: Brent is down to around $88. Volatilities have spiked. The VIX reached over 31 percent last week, and the crude oil VIX went from about 15 percent at the end of August to over 37 percent last week.
The spark appears to have been mounting evidence of a slowdown in Europe and China. Ebola might have been a contributing factor in the last week or two, but in my view the economic weakness is the main driver.
I admit to being like the title character in My Cousin Vinnie. He had difficulty sleeping in the Alabama country quiet, but slept like a lamb in a raucous county jail. Times like these are more interesting, anyways.
So it turns out it was too quiet out there.
And remember. Today is the 27th anniversary of the ’87 Crash (one of the formative experiences of my professional life). Octobers are often . . . interesting (the most dangerous word in the English language). So the markets bear watching closely. If you aren’t interested in them, they may well be interested in you.