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What is Causing the Market Volatility Surge?

 5 min read / 

The volatility of financial markets seems to have increased substantially over the last period. The reason for this resides in the fact that financial markets themselves are more and more interconnected with the political sphere.

The first example emerges from the recent increase in trade tariffs that US President Donald Trump imposed, especially towards China. Markets immediately reacted, with a strong setback on both sides of the Pacific. The largest exchanges, such as the NY Stock Exchange and the Shenzhen Stock Exchange, dramatically dropped on some days, then recovering towards more normal patterns in the following days. Another example is related to the recent mandate that the 5-Star Movement and the Northern League got for ruling Italy with the new government. The new leading coalition was perceived by markets to be anti-conformist and anti-Europe, leading to a sudden increase in the BtP yields and, as a consequence, a surge in the value of the spread against the German Bunds. 

A high degree of volatility indicates uncertainty. Going back to the example of Italy, a country that is perceived to have higher risk, thus having higher volatility, will have a lower demand of its sovereign bonds, given an unchanged risk-price relationship. In order to maintain the previous equilibrium, it will be necessary to re-calibrate the government bonds with higher yields that can reward investors with higher earnings in light of a higher risk.

The political moment we are living through at a global level is highly turbulent. The greatest powers in the world are increasingly adopting economic and political measures with a nationalistic and protectionist shade, aimed at overcoming the previous liberalisation period. This paves the way for a period of uncertainty to which we were not used to, at least since the aftermath of the 2007/08 global financial crisis. 

But is it possible to have a tangible reference point when it comes to evaluating the recent increase in volatility? What are the indexes to consider in order to understand the magnitude of such an increase?
The factors or variables to take into account can be reduced to three main ones.

ViX Index

The ViX Index is considered to be the ultimate index of volatility, tracking the general level of uncertainty prevailing in markets. Created in 1993 by the Chicago Board Options Exchange, the largest exchange globally for derivatives trading, the ViX bases its estimates on an algorithm that considers the market price of put and call options on the S&P index, with maturity of at most one month from the current date. 

The ViX Index has now stabilised at a level of around 13 points starting from February, after having dropped in the month of January. Previously, the average, from January 2017, had stabilised around 10 points, meaning that the base volatility has increased by 30% on average according to the index.

Looking backwards, the index had registered higher peaks during the last global financial crisis, being around 20 points, which explained why it is nick-named “fear index”.

Financial Securities

Another way of assessing the level of volatility is taking into account the change in the fundamental values of financial instruments that are traded in the Stock Exchanges, or the Over-The-Counter markets. There are some asset classes that are more useful in this sense.

The first is the S&P 500, the index that follows a portfolio of the largest 500 US companies in terms of capitalisation. Starting from 2009 the index has undertaken a constant growth path. However, growth seems to have been less stable starting from February of this year, with downward jumps that have stalled the upward trend. At the same time, across the Atlantic the FTSE 250 has shown the largest dwellings over the last semester, confirming the phenomenon in the European area.

The other useful asset class is fixed income securities, namely government bonds. The conclusion is the same. The 10-year yield of the BtP, the Italian government bonds, showed a sudden great surge during last May, exceeding the 3% limit from a level of 1.7% in the previous months. The sovereign bonds of other European countries followed the uncertainty wave brought on by Italy. All the while, the EU is increasingly criticised, considered unable to properly face the immigration problem and to accept austerity measures imposed by the central authorities for the control of public debts. However, the most interesting phenomenon is the flattening of the short-term and long-term yield curves. For instance, while at the beginning of 2016 in the US the spread between the 2-year yield and the 10-year yield was well above 1%, at the moment it is just below 0.4%. The explanation is rooted in the fact that investors are less confident about long-term investments, given the blurred and volatile horizon, and thus prefer a more short-term investment. It is worth underlining that short-term investment is more liquid and is thus easier to dispose of, in case adverse events took place in the market.

Banks

Banks can turn out to be a solid benchmark for measuring market volatility. The higher the volatility of the markets, and the higher investors’ uncertainty, the more will they tend to entrust their investment decisions to banks. Moreover, lower volatility ends up narrowing the gap between different investment gains, thus passive investment strategies, including stock indexes, spread easily among investors, in part due to the lower investment management fees incurred. 

During 2017, banks’ revenues coming from their trading activities dropped significantly. Forbes reported in the third quarter of 2017 a more than 22% decrease in average revenues, with respect to the same period of the previous year, from their FICC (Fixed Income, Currencies and Commodities) trading activity. In particular, JP Morgan resulted to be the worst performer, with a minus 27%, according to Forbes’ figures.

All these elements combined indicate that volatility is taking a strong foothold in global financial markets.

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