Buy Vol For 2013

Four years of heavy central bank intervention have driven one cross-market measure of risk to historic lows.

The Risk Aversion Index (RAI) from Leuthold Group, a Minneapolis-based quantitative research firm, is currently at levels unseen for decades. As can be seen in the chart below (enlarge it for a clearer view), levels of risk aversion are now well below those of the 2005/6 peak of the credit bubble, as well as undershooting other previous cyclical troughs.

By contrast with the widely followed VIX index, the US equity market’s “fear gauge”, the RAI provides a more holistic view of market volatility.

The RAI has ten equally weighted components, all measures of market risk: the global credit sector provides five (the TED spread, swap spreads, US corporate credit spreads, global high yield credit spreads and emerging market sovereign credit spreads); two come from the equity markets (the VIX and the rate of change in the MSCI Emerging Markets/MSCI Developed Markets index ratio); and the remaining three RAI index components track rates of change in key currency/commodity market indicators (the CRB index, the US dollar index and the euro/yen cross rate).

According to Leuthold’s Chun Wang, the creator of the RAI, eight of the ten index components currently show well below-average risk (only US credit spreads and the US Dollar FX index have readings that are close to historical norms).

“The idea behind the RAI is that greed or fear knows no geographical boundaries or asset class classification,” Wang told me last week. “A typical risk event usually starts in a particular segment of the market. Then, when it becomes significant, it spreads to other asset classes.”

Often, one might add, the credit markets lead the way in signalling a problem that then spreads to other asset classes like equities and commodities: think the Russian crisis of 1998 and the markdown of sub-prime debt securitisations in 2007, both precursors to broader equity market slump.

One surprising thing about the last few years is that central bankers’ suppression and control of interest rates hasn’t been met by a typical reaction: greater volatility in the foreign exchange markets.

This may reflect the subdued role of other currency market players, says Tim Carrington, global head of FX at RBS. Writing earlier this year, Carrington spoke of “a dramatic drop in the natural flow of FX from trade and earnings flows” and a “marked reduction in the liquidity provided by hedge funds and investment banks”, while central banks have become “much larger and more powerful players” in foreign exchange.

But, adds Carrington, “tail” risk—the likelihood of extreme events—is increasing.

If history is any guide, central banks’ attempts to counter natural market forces will eventually fail. The last decades have seen many instances of price- and rate-fixing experiments ending in a blow-up in volatility: Nixon’s attempts to cap the gold price at $35 an ounce and the Bank of England’s disastrous attempt at fixing the sterling rate in 1992 are two notable examples. Can the Bernanke/Draghi/Abe “put” option can keep asset prices inflated, and currency and interest rate volatility depressed, indefinitely?

“Historically,” says Leuthold’s Wang, “the tendency for the RAI to rise from the current low levels over the following 3-6 months is extremely high.”

Getting the timing right on calls of volatility blow-ups is tricky, though, Wang concedes.

“Low-risk regimes typically last much longer than high-risk regimes,” he says, “and so we wouldn’t be surprised if this ultra-low risk aversion environment continues for a while longer.”

But the RAI index chart is surely a warning that we shouldn’t expect the benign market environment of the last couple of years—euro crisis notwithstanding—to last indefinitely. Buying vol could be the trade of the year in 2013.

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