Traders think volatility in US stocks will get even lower as central banks turn dovish

Chris Hondros/Getty Images
  • US stocks have rallied sharply so far this year, either recouping all or most of the abrupt selloff seen late last year.
  • Expected volatility in US stocks looking one month ahead recently fell to levels not seen since August last year.
  • Futures traders, as a collective group, expect volatility in US stocks to fall even further in the period ahead.
  • This may leave stocks vulnerable to correction should any unexpected economic, monetary policy or geopolitical shocks.

US stocks have rebounded strongly this year, supported by a dovish shift from the US Federal Reserve, thawing trade tensions with China and and stronger-than-expected corporate earning results.

After plunging nearly 20% late last year, the S&P 500 rose to record highs last week. The tech-heavy Nasdaq also climbed to fresh peaks, while the Dow Jones Industrial Average now sits just below its previous high set in October last year.

It’s been quite a turnaround with the selling and volatility seen in the final quarter of 2018 now all but a distant memory.

The VIX — an index that uses options pricing to measure expected volatility in US stocks looking one month ahead — recently fell to 11.03, the lowest level since August last year.

At 12.73 last Friday, the VIX still remains well below the 36+ levels seen during the peak of the US market selloff seen in late December.

Volatility is not only low but it’s expected to remain that way, according to the chart below from Morgan Stanley.

Morgan Stanley

Using data from the US Commodity Futures Commission (CFTC), it shows net speculative positioning in VIX futures recently fell to the lowest level in over 10 years, implying that traders expect even lower volatility in the period ahead.

“Investors are heavily positioned for lower volatility even though it is already extremely low!,” Morgan Stanley said in a note

“Volatility markets are looking particularly stretched.”

Along with other indicators, Morgan Stanley believes this indicates an elevated degree of complacency among investors.

“Although not all sentiment indicators look stretched at this time, we have seen an increasing number of tactical indicators moving to elevated levels in the last couple of weeks,” it said.

“For example, our FX team’s Global Risk Demand Index (GRDI) moved to within a whisker of +2 standard deviations which usually marks complacency, the S&P 500 reached a new all-time closing high while the RSI on MSCI AC World index moved above 70, its highest level since January 2018.”

Given the tailwinds provided by Fed, progress in trade talks with China and corporate earnings, along with an improvement in the Chinese economy in the early parts of this year, it’s easy to understand why stocks have rebounded and volatility has fallen.

However, with so many now positioned for these trends to continue, it does leave stocks vulnerable to any unexpected economic, monetary policy or geopolitical shocks.

As has been seen several times over the past 18 months or so, while volatility can remain low for a considerable period of time, when it lifts, it tends to be quite sharply.

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