Where next for vol.?

Nowhere. Unless it’s lower. Of course. That’s how things work. That’s how things have to work. That’s how things must work.

Because as Citi recently put it, “trades and strategies which explicitly or implicitly rely on the low-vol environment continuing are becoming more and more ubiquitous.” That ubiquity begets feedback loops – i.e. self-feeding dynamics that, when underwritten by radical central bank transparency, optimize around themselves. They work because they have to. Rebelling against the prevailing system entails foregone carry, underperformance, and to quote Deutsche Bank’s Aleksandar Kocic, “a high probability of gradually losing small amounts over an indefinitely long period of time, keeping in mind that persistent small losses over an indefinite time period could lead to large cumulative losses.”

What happens in the interim? What are the “trades and strategies” that Citi refers to? What comprises the feedback loops? You know the answer – or at least you should. Here’s JPMorgan’s Marko Kolanovic to remind you:

We think that for the next market crisis, irrational exuberance in the ‘tech bubble’ sense is not needed. The reason is the prevalence of quantitative and passive strategies that don’t decide based on emotions, but rather based on measures such as the level of interest rates, volatility, price momentum, or bond-equity correlation. Examples of these strategies include Volatility Targeting, Low Volatility strategies, Trend Following strategies, Risk Parity strategies, Dynamical hedging strategies, Volatility selling strategies, and others. In addition, there are relative value strategies that transmit risk premia compression across asset classes and strategies.

As Deutsche Bank notes to start the week, five-decade lows in realized vol. are not entirely a mystery. “Together the unemployment rate and the ISM explain the bulk (68%) of the variation in realized volatility,” the bank writes, in an asset allocation piece dated Monday. But while low realized vol. may not be a complete conundrum, the confluence of factors operating here is rare. “Since the 1960s, there are only 19 months when the ISM was 58 or higher and the unemployment rate was less than 4.5%. That is only 2.7% of the time,” Deutsche continues.