June 13, 2014 2:05 am JST

Low market volatility stokes bubble fears

TOKYO -- Financial markets of late are evincing a disconcerting calm that recalls past periods of low volatility that led to sudden downturns.

     The CBOE Volatility Index, a measure of market expectations of 30-day volatility for U.S. stocks, sank to a seven-year low at the end of last week. The greater the rise in this "investor fear gauge," as the VIX is often called, the more wary investors are of a precipitous drop in stock prices. The low level at present indicates just the opposite.

     This means the markets are resounding with an optimism similar to that seen when the U.S. and Europe were at the tail end of a financial bubble nearly a decade ago.

     The trend is not confined to stocks. Price fluctuations for currencies, bonds and commodities are low as well. As Goldman Sachs' Dominic Wilson notes, it is unusual for financial assets across the board to experience a simultaneous decline in volatility.

     Monetary easing worldwide is one factor at work. Over the last few years, central banks have been buying up huge quantities of government bonds and other assets. While the banks may be taking on risk from private-sector investors, many market watchers say a deterioration of the economic environment is not likely to destabilize market value.

     At the same time, easy-money policies are smoothing the ups and downs of economic outlooks. Few investors anticipate sudden recoveries in advanced nations. But many expect central banks to prop up economies by keeping easing measures in place should growth decelerate.

     One ought to welcome the salubrious effects such stability may have on growth. But the persistence of exceptionally low volatility may have side effects.

     "I am a little bit nervous that people are taking too much comfort in this low-volatility period," Federal Reserve Bank of New York President William Dudley remarked recently. "As a consequence, they'll take more risk than really what's appropriate."

     Indeed, investors intent on seeking gains amid narrow price movements tend to increase their trading leverage, making them more inclined to use low-interest currencies to buy high-yield assets. This is what happened in the mid-2000s, and it contributed to the 2007-08 financial crisis.

     Markets are starting to take note. As George Magnus, senior economic adviser to UBS, wrote last week, tranquility may "merely prove to be the calm before the storm."

     But not all are so worried. In light of moves to strengthen financial regulations, "the risk that low volatility would create a bubble is declining," said Takafumi Yamawaki at JPMorgan Securities Japan.

     Market participants are carefully watching to see whether imbalances may be building up in markets as the U.S. Federal Reserve looks for an exit from monetary easing.