Where Has All the Volatility Gone?

by: David Andrew Taylor

The past few months have seen relatively low volatility levels in the currency markets. As an options trader, I live and breathe by the level of an option's volatility. In fact, I obsess over it. I spend more time evaluating volatility than any other element of trading. Higher volatility means more "meat" on an option. It also means a few less sleepless nights throughout the month, but it's a tradeoff. Here's a quick look at the option volatility for the euro for the past five years:


dat chart

Looking at the chart, you can see that volatility has sort of, oh, what's the phrase I'm looking for... um, how about: fallen off a cliff.

I've been trading for about 13 years now, and this is by far the lowest volatility I've seen. The market isn't impervious to this. There have been several write-ups around that have pointed out the decline in volatility, and it's even hit the mainstream media. One of the best excuses that some have come up with, is that markets have become more efficient overall. Some say that we are more informed about what is happening with the economy, and hence there are generally no "surprises."

Even our own Federal Reserve is taking great strides towards more transparency, removing a lot of the guesswork as to how our economy will perform. The information and tools at the disposal of our central banks have been able to keep our bankers more effective at moderating the ups and downs of the economy.

I look at three instruments as "report cards" of how an economy is performing; the currency, bond market, and equity market of a nation. Strong equity markets, factored in with the strength of the currency, as well as the level of interest rates from the bond market, are a pretty good indicator as to how the economy is performing. This is one reason that I look at these three markets collectively in order to predict moves in the currency market.

The past year has seen relatively tight ranges in the currency markets. I attribute this to the lack of surprise in the markets from information that we are receiving from our Fed, as well as other central banks throughout the world. That got me thinking: Could this same efficiency be helping our central bankers keep our recessions a little less volatile? I think so. Here's the latest chart on GDP:

dat2

The last recession was by far the mildest we've ever seen in our modern history. In fact, if you look at the chart, officially we never even had a recession. We never went below 0% into the negatives that are common with recessions. Let's face it, if you're going to have a recession, make sure there's some blood in the streets and take the growth rate below zero.

There are some that have called for a recession due to the housing market. The housing market itself has mellowed out since its sharp decline over the past few months. Some are even using the term "bottom" to describe the housing market. I'm mostly in that camp as well, although the jury is still deliberating. Nonetheless, I'm going to go on record as suggesting that if we are going to have any kind of "recession" from the housing market, we are, in fact, in it right now. The recent mild dip in the GDP is in essence our efficient recession. Kudos to the Federal Reserve and other central banks for being able to guide our economy in a very efficient manner.
Federal Reserve
There is a downside to this thinking as well. Take a look at the upside on the GDP: We've not hit above anything that would be considered booming, either. I think the efficiency of the Federal Reserve, as well as that of other central banks throughout the world, has been able to maneuver the world economies in such a fashion that our recessions are mild, and our economies never really get too overheated. Likewise, the lack of volatility in the economy has helped out in keeping our markets relatively stable.

Volatility has picked up somewhat at the onset of this year in the currency market. I don't think this is indicative of any pickup in volatility to the economy. We are more likely seeing a realization in the markets that the U.S. economy is firmer than what was perceived finishing up 2006. With that, we are seeing a move back into the greenback.

But, I'll be keeping an eye on volatility.