When real interest rates are lowered, financial volatility is suppressed.

Bessent, Scott

Global political uncertainty has rarely been higher in recent memory. Brexit, North Korea, upcoming Italian elections, and fresh concerns about a possible Trump impeachment loom, and a major geopolitical event seems increasingly possible. And yet implied volatility has rarely been lower, whether for equities, interest rates, currencies, or commodities. One measure of implied volatility, the VIX, closed below 10 on May 8, something that has happened only nine times since 1990.

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Importantly, it is not just implied volatility that is so low. Realized volatility has also been remarkably dormant. Indeed, over the past twelve months, the rolling thirty-day realized volatility on the S&P 500 has averaged a paltry 9.4.

Why have realized and implied volatility been so low, despite the plethora of known risks? Market pundits have suggested a number of possible explanations: the rise of volatility-selling ETFs, short gamma positions among broker-dealers, and the shift from active to passive investment management. Recently, Mark Mobius of Templeton Advisors even suggested that social media and the spread of fake news could be to blame. By his telling, the glut of confusing headlines is causing people to dismiss new information, because they can no longer be sure what is true.

While each of these suggestions has some merit, the true explanation is likely far simpler. Just as the nature of water changes when the temperature drops below zero degrees Celsius, so too does the nature of financial markets when real interest rates become negative. Put simply, when central banks push real rates below zero, financial volatility freezes.

The chart shown here plots a smoothed average of the VIX index against a lagged measure of the real federal funds rate. The image is highly suggestive. In short, volatility appears to react to changes in real interest rates with a lag of one to two years years. When real interest rates are high, so too will be financial market volatility. And when real interest rates are lowered, financial volatility will likewise be suppressed.

Why might volatility show such a strong relationship with changes in interest rates? In a 2006 paper, Raghuram Rajan, former governor of the Reserve Bank of India and now a professor at the University of Chicago, suggested that low policy rates might induce procyclical risk-taking in financial markets. He highlights the incentives of insurance companies with fixed-rate commitments as an example. When interest rates fall, they have no alternative but to seek out riskier investments. If they buy low-return but safe investments, they will fail to generate sufficient returns to meet their obligations. If they take on higher-risk and higher-return investments, they at least have some chance of survival. Rajan makes a similar argument for hedge funds with one and twenty fee structures. When rates are low, they seek out higher return investments and take on leverage to juice performance. If they stick to safe investments, they may not meet their 1 percent hurdle and earn lucrative incentive fees. In other words, low policy rates incentivize financial market participants to "reach for yield."

Tobias Adrian and Hyun Song Shin come to similar conclusions about the procyclical behavior of market participants in a 2008 paper published by the New York Fed. They show that the growth rate of financial institutions' balance sheets is directly related to the degree of ease in monetary policy. When policy is loose, balance sheets grow rapidly and with this so does financial market liquidity. In contrast, when monetary policy is tight, balance sheet growth is slowed and financial market liquidity declines. Further, Adrian and Shin suggest a virtuous cycle in which a rise in asset prices leads to an improvement in the net equity position of financial intuitions' balance sheets, allowing for more balance sheet growth and a further rise in asset prices.

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In other words, low interest rates spur a reflexive feedback loop in which more rapid balance sheet growth generates increased financial market liquidity, thus raising asset prices and dampening measured volatility, allowing for further balance sheet growth.

What might break this feedback loop and cause the freeze in financial volatility to thaw? Inflation. As the U.S. labor market continues to tighten and wage growth accelerates, the Fed will raise interest rates to prevent the economy from overheating. Unfortunately for markets, this is where the analogy with water ends. As temperatures start to rise and winter comes to a close, the spring thaw brings with it new blooms and sunnier days. However, as real interest rates rise above zero, the thaw in financial volatility will not feel like springtime, as the positive feedback loop described above begins to go in reverse. Higher interest rates will lead to slower balance sheet growth, resulting in less market liquidity, more market volatility, and ultimately lower asset prices. Feedback loops are great on the way up. As they unwind, the experience is typically far less enjoyable.

Scott Bessent is CIO and founder of Key Square Capital Management. Francis Browne and John Zhou of Key Square also contributed to this article. The views presented here are purely the opinions of the author and are not intended to constitute investment, tax, or legal advice of any nature and should not be relied on for any purpose.