Financial markets have been quiet, maybe too quiet, for much of this year. Of course, in saying this it increases the likelihood of it ending sooner rather than later! Indeed, since drafting this speech, the VIX has risen to its highest level since February.
If I had told you that there were heightened tensions in the Middle East and Eastern Europe, uncertainty about the turning point in US monetary policy, a succession of strong US job numbers, uncertainty about the future direction of policy in Europe and Japan, as well as increased concern about the strength of the Chinese economy, you would not be expecting that to make for a benign time in financial markets. But that is what we have seen for much of this year. The graph shows measures of volatility in fixed income, equity and foreign exchange markets. At some point this year, all of these have fallen to historically low levels. There has been little reaction to any of the events I have described. To the extent there has been any, it has been very short-lived. (Graph 1)
In the past few weeks, volatility has picked up, predominantly in foreign exchange markets, which I will come back to a bit later. But even so it has not yet returned to a ‘normal’ level of volatility.
So volatility has been low for a prolonged period of time in the face of a number of events which individually would normally be associated with high volatility, let alone all of them happening at the same time. Why is this happening? A number of explanations have been advanced, but I don’t find any of them particularly compelling, mostly constituting, at best, only ex post rationalisations.
Macroeconomic outcomes for the world in aggregate have been relatively stable and that may be part of the story. World growth has been running at around 3½ per cent for the past couple of years and the latest forecasts have it continuing at that pace for the next year or so. But the relatively stable aggregate outcome masks quite a lot of variation across countries. A good example is the high volatility in growth in the first two quarters of this year in the US and Japan, the former resulting from weather, the latter from the consumption tax increase.