To set the scene let me return to the middle of last summer, when volatility was exceptionally low across a range of financial markets; both compared to the period of heightened volatility that we saw in the crisis years and the period preceding it. That can be seen from this spider chart which shows measures of short-term implied volatility for a number of assets relative to these two periods. Anything less than zero is less volatile than the past, with the opposite true for positive plots (Chart 1). Our market intelligence suggests that a number of factors contributed to these stable outcomes. There was a relatively low level of uncertainty about the macroeconomic outlook. The extraordinary policy easing from central banks had depressed both implied and realised volatility. Forward guidance, as well as repeated rounds of quantitative easing had also led to market participants to take comfort from the mantra of “low-for-long”. This in turn incentivised investors to “search for yield”, which of course was an intended consequence of the monetary stance, but which depressed volatility and compressed risk premia in a selfreinforcing cycle. Since last summer volatility in many financial markets has picked up and there have been a number of short-lived episodes of extreme volatility and impaired market liquidity. Implied volatilities have risen and in a number of the cases I showed earlier have returned to around pre-crisis levels (Chart 1).
The performance of the US Treasury market was also materially affected on each of these days, such that much smaller trades than normal moved prices. But in each of these cases there were stabilising forces that meant volatility subsided and liquidity returned relatively quickly. In the case of the 15 October event, what had been a crowded trade was pushed so far from prices viewed as “justified” by fundamentals that market participants were willing to provide support to the market. Similarly there was a reappraisal of the fundamentally justified level of the Swiss franc in the days that followed the removal of the peg, following public comments by the SNB. Volatility declined, if not all the way back to the pre-news level, relatively quickly following these initial spikes. This is most true of the 15 October episode: the implied volatility of 10-year interest rate swaps retraced about half of its upward move after two days, and was back to pre-October 15th levels within just two weeks. This quick stabilisation helped to limit contagion to other markets. Neither the increase in “baseline” volatility, nor the recent episodes I have just described, in of themselves materially affected stability in the United Kingdom. For us then, the question becomes what lessons can we learn? Why have volatility and liquidity evolved in this way?