When mighty central banks killed volatility

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Updated: 19 February 2020

We are not contrarian by nature but several disturbing facts over past weeks are starting to create this feeling of uneasiness. It is almost as nothing seems to matter to investors. Using sentiment readings in order to try picking market turning points is not an easy task as markets have performed well at times of extreme sentiment. We are not suggesting one should use sentiment as a sole factor in positioning, but we believe current psychology among investors is reaching extreme levels. Sure, we acknowledge the possibility of the market going into the FOMO melt up phase, but that seems now to be the consensus trade. We all know these types of consensus views seldom produce extraordinary gains.

We note the increasing amount of people we talk to now almost abolishing the view markets can
Move lower. Volatility is according to many now extinguished as central banks run the show. Not
only do people confuse low volatility with low market risks, but many have seen portfolio hedges
only cost them money. In a world where money managers are being evaluated on an extremely
short term basis, the short-termism focus creates an interesting perception on why using hedges.
Call it the new neutral or complacency, but investors acknowledge less and less risk in the system
and are at the same time willing (forced) to take on more and more risk they probably wouldn’t in
more ordinary times.

Correlations are still low (despite having popped small over past days), VIX is down to very low levels, last at 12.6.

Central banks seem to have succeeded in forcing people to take on risks they probably don’t like
taking (nor believe in), but in this world of short-term yield chasing and markets having gone one
way only, thinking about possible risks is out of fashion.

Central banks have created an impression that risk (almost a patriotic act) is necessary for
economic growth and the central bank PUT being the evidence they actually control risk as well.
It is almost as if the central banks have ultimately managed controlling the psychology of
investors. We ask ourselves if we are reaching that inflection point as the Pavlovian investor
seems to have totally lost the critical thinking about the overall market?

If assets are in bubble territory or not nobody knows. For us the bigger bubble that seems to be
developing is the strong belief in central banks being able to control everything ranging from
markets to investor psychology. Central banks are seen as omnipotent, and that is starting to
really disturb us. The markets could continue the melt up trajectory, but recent price action in
various assets, the complacency by so many, along with a few of the most bearish people we
know ”giving up” lately suggests one should continue to analyse the downside exposures in the
portfolios. Volatilities are still trading relatively low and offer interesting hedging possibilities if
one is willing to realistically think about the trajectory of the market beyond the “obvious” melt up.
Is it time to be bullish, disregard risk factors and join the growing crowd of investors all chanting
“volatility is extinguished”?