Low volatility may not last, says BIS report

Low levels of asset price volatility owe much to structural changes in the market, but a slower economy could still push volatility up again, according to a Bank for International Settlements (BIS) report.

The last couple of years have seen unusually low volatility in stock prices, interest rates and corporate credit spreads, with short-term interest rates hitting 20-year lows.

According to the BIS' volatility study group, led by Bank of Italy researcher Fabio Panetta, the calming of the financial markets is probably not related to the general drop in volatility of macroeconomic data such as output and employment. This 'great moderation' emerged a long time before the drop in financial market volatility.

Instead, much of the improvement is due to the development of the risk markets - higher liquidity, the use of more sophisticated risk transfer products allowing rapid hedging, and the increase in options supply bringing down prices and thus implied (and possibly realised) volatility.

The relative calm of the financial markets does not simply represent a quiet period in world history. In fact, the past two years have seen sharp oil price increases, the US car industry crisis, terrorist attacks, a tsunami, hurricanes and war, the BIS points out, without producing rises in volatility across the markets.

But investors should not expect the calm to continue indefinitely. Many of the factors involved are cyclical - return on investment is high and balance sheets are generally healthy, representing the current economic expansion, but this will not last for ever. The move by central banks to more frequent and smaller changes in interest rates, which has also reduced market volatility, could also be reversed.

The equity markets in particular, the BIS said, are not expecting continued low volatility. "Financial markets seem to concur with the view that the reduction in volatility is in part temporary. For example, despite the prolonged period of low volatility, the equity premium implied in stock prices does not seem to have declined. If the reduction in the volatility of stock returns turns out to be of a more permanent nature, sooner or later the equity premium will have to adjust downwards, implying a permanently higher equilibrium level of stock prices," the BIS report said.