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Volatility Soars, Is a Broader Bear Market Far Behind?

Volatility Soars, Is a Broader Bear Market Far Behind?

2014-10-09 20:47:00
John Kicklighter, Tyler Amend,
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Volatility levels have been rising consistently across various asset classes over the past few months, but the surge from the equities side (measured in the VIX Index) this past session has generated a lot of trader interest. An increase in market activity translates into better trading conditions, and is therefore a relief for traders in currencies and other asset classes. This is particularly meaningful considering we are coming off multi-year – if not record in the case of FX – lows in volatility. The question is whether this climb will last or is just another ‘false dawn’.

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A number of elements have come together to heat underlying conditions. Among the higher profile developments to spur a turn in activity, we have seen macroeconomic indicators sour and spur downgrades in growth forecasts; warnings of undervalued risk in the financial markets made by numerous authorities (Fed, IMF, Bank of International Settlements among others); and the beginning shift in the accommodative monetary policy that had deflated market ‘risk’ in the first place.

Volatility Soars, Is a Broader Bear Market Far Behind?

Charts Created by John Kicklighter, Data from Bloomberg and FXCM’s Marketscope 2.0

As a whole, volatility has increased across all major asset classes since the beginning of September with the most notable in Equities now 40 percent higher than where it started the year (as seen in the image above). Volatility measures in FX, commodities, ‘yields’ (Treasuries), and Emerging Markets have are still below the levels they started the year at, but they are significantly higher than mid-year lows and stadily rending higher. This broad spectrum increase in volatility has highlighted the risk profile of each asset class while increasing the return expectations of investors in all markets. The dispersion of price around long term averages is the main driver to trading profit.

Volatility Soars, Is a Broader Bear Market Far Behind?

Charts Created by John Kicklighter, Data from Bloomberg and FXCM’s Marketscope 2.0

The VIX and S&P 500 are particularly well adept at signaling the fear factor and crowd mentality that exists in the markets. With the VIX derived from options (used heavily as ‘insurance’ to underlying stock positions), it stands as a particularly good reading for both activity and conviction. In other words, each significant increase in the VIX usually aligns to a relative drop in the S&P500 (as can be seen in the chart above). Through the market’s gradual rise over the past few years, short-lived pullbacks in the underlying market aligned to short-lived jumps in volatility. And while the capital market gauge hasn’t entered a deeper decline, volatility is showing unusual endurance.

Volatility Soars, Is a Broader Bear Market Far Behind?

Charts Created by John Kicklighter, Data from Bloomberg and FXCM’s Marketscope 2.0

Should volatility continue to rise, it is likely to do so on the basis of growing concern over not just heavy market swings, but also the threat of a broad ‘risk off’ shift. This translates into a reversal in equities, high-yield assets, carry trade, commodities and other asset classes that are sought in good times and divested during uncertainty. In the graph above, we can see a number of the top market benchmarks for financial sentiment. For FX traders, that is would undermine fundamentally questionable currencies like the Euro and leverage the appeal of the US Dollar for liquidity. However, the most distinct relationship would likely be USDJPY and other yen crosses through a pullback in carry trade.

Volatility Soars, Is a Broader Bear Market Far Behind?

Chart taken from FXCM’s Marketscope 2.0

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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