Trading – volatility has dropped significantly after the Brexit vote

Market volatility increased in the run-up to Britain’s referendum on the EU and hit a peak on the day following the vote for Brexit. But since then volatility has sunk to historic lows, at least according to the premier gauge of market stress – the CBOE Volatility Index, or VIX. This index measures the market expectations of near-term volatility in the S&P 500 stock index via options prices.

VIX_Jul26

Source: CBOE

The VIX raced up on June 24th to hit 26, a level not seen since the height of the market turmoil in February and well above its long-run average of 20.

But since then the so-called fear gauge has collapsed, closing below 12 for  the first time. Brexit was supposed to inspire record levels of volatility, so what went wrong?

Bull Market

The Brexit vote is just one of many factors weighing on market sentiment, from fears about Europe’s banks to the prospect of higher US interest rates and a hard landing in China. So why hasn’t it produced the volatility expected? Firstly, it did – but only for a few days. Even sterling – prime market proxy for the Brexit vote – has settled around a level and doesn’t want to budge too much.

Secondly, stock markets seem immune to just about any bad news. The S&P 500 has not only rallied since February but has punched out a string of new record highs.

The VIX tends to drop when the market is up, with the two exhibiting a clear inverse correlation. When the market is notching up record peaks there is little scope for volatility.

Trouble Ahead?

Could this low volatility market be a sign of stress ahead? It’s possible that we could be in for a rougher ride once traders come back from their summer holidays in September. Many traders would assume that a low VIX reading means it’s time to knuckle down and await the sell-off.

But the VIX is not a leading indicator – it shouldn’t be used to predict market behaviour, but is rather a confirmation of the direction. When the market is falling, the VIX goes up (usually), as it is really a measure of the cost of portfolio insurance. So a low VIX reading does not necessarily mean we’re in for a period of selling.

Forex

GBP_volatility_July26

Source: CBOE

Forex markets are also a lot less volatile than immediately after the Brexit vote.  Sterling volatility, as measured by the CBOE/CME FX British Pound Volatility Index has dropped from a peak of just shy of 22 to a level between 17 and 18. That is still higher than average but a sign that some of the immediate post-Brexit nerves have gone.

Euro volatility has also plunged since late June, when it flirted with a reading of 15 – a level not seen since 2012. This has now dropped back to around 9.

Euro_volatility_July26

Source: CBOE

The yen is another matter. Yen volatility continues to increase as markets are moved by conflicting speculation on the path of Japanese monetary policy. Yen volatility is now at its highest in three years as traders brace for a surprise from the Bank of Japan.


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