Streetwise Professor

October 19, 2014

It *Was* Too Quiet Out There

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis — The Professor @ 5:28 pm

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.

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  1. As a matter of interest, have you given any thought to where the floor might be on the oil price now?

    I have neither dog in the fight nor view, but is the retreat from $100+ sufficiently understood to tell us how much further it can go?

    $80? $70? $36?

    Comment by Green as Grass — October 20, 2014 @ 2:34 am

  2. @Green-take this with a grain of salt, since I am not writing it from my super-yacht. Right now the supply risks are on the downside (in terms of price), but the main driver will be demand. Will Europe continue to weaken, will it potentially see a repeat of the sovereign crisis (the spike in PIGS yields suggests that’s not out of the question), what will happen to China. I think the demand risks are tilted to the downside too. I don’t see $36 as a realistic alternative, but mid-$70s is.

    The ProfessorComment by The Professor — October 20, 2014 @ 10:05 am

  3. The usual suspects seem to be much quieter about these sorts of prediction these days having done rather poorly in 2008…

    Comment by Green as Grass — October 21, 2014 @ 6:34 am

  4. Incidentally, happy Trafalgar Day!

    Comment by Green as Grass — October 21, 2014 @ 8:43 am

  5. @Green-Ditto! Thanks.

    Doesn’t “England expects every man will do his duty” sound so quaint?

    The ProfessorComment by The Professor — October 21, 2014 @ 9:20 am

  6. @Green. Yes they are.

    The ProfessorComment by The Professor — October 21, 2014 @ 9:21 am

  7. Nowadays England would “feel entitled” rather than “expect”.

    Comment by Green as Grass — October 21, 2014 @ 11:04 am

  8. @Green. Duty? What’s duty? “England accepts you’ll do something if you feel like it. Or not.”

    The ProfessorComment by The Professor — October 21, 2014 @ 12:34 pm

  9. “England feels entitled to have something done for it by someone else, in no uncertain terms” somehow lacks the concise elegance of Nelson’s original.

    Comment by Green as Grass — October 21, 2014 @ 1:00 pm

  10. Also, I doubt a philandering, one-eyed, one-armed admiral would be in charge of the fleet today (which is too bad, because he’d be interesting, at the least).

    Comment by Blackshoe — October 21, 2014 @ 1:53 pm

  11. @Blackshoe. No zippers back then, so zipper malfunction impossible! Button malfunction maybe.

    Seriously, though, you raise a good point. There is a price to be paid for political correctness. Historically, peacetime militaries have promoted conformists and martinets and political operators, many of whom end up being failures when the shooting starts, or at the very least never display anything close to military genius. The traits selected in peacetime are not adapted to wartime and vice versa. The transition from one to the other is painful, and leads to a huge churn in leadership.

    The ProfessorComment by The Professor — October 21, 2014 @ 3:05 pm

  12. @Green. Spot on. Evidence of social devolution.

    The ProfessorComment by The Professor — October 21, 2014 @ 3:06 pm

  13. Thank God I have done my duty. Better words were never spoken and how he would abhor what he now overlooks.

    Comment by pahoben — October 21, 2014 @ 9:45 pm

  14. I am reminded of a quip I once read to the effect that the French army has historically often been clearly the best, in between wars.

    Comment by Green as Grass — October 22, 2014 @ 3:01 am

  15. “Doesn’t “England expects every man will do his duty” sound so quaint?”

    Maybe you should ask one of the badly burned Falklands Veterans.

    Comment by jon livesey — October 22, 2014 @ 3:00 pm

  16. @jon. Falklands War was 32 years ago. It wouldn’t happen now. That is sort of my point.

    The ProfessorComment by The Professor — October 22, 2014 @ 4:59 pm

  17. For me, the nadir was when Iranian gunboats captured the crews of some Royal Navy craft in the Straits of Hormuz. One of the RN sailors admitted he cried when the Iranians took his iPod away.

    I am less sure than I was that this is still wholly the navy of the Falklands and Trafalgar.

    Comment by Green as Grass — October 23, 2014 @ 4:07 am

  18. @Green. Definitely. Here’s my take on that episode from the time. Sounds like we were/are on the same page.

    The ProfessorComment by The Professor — October 23, 2014 @ 8:21 am

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