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Is Christmas Volatility Ahead?

As we explained in our last update, even as volatility spiked and panic seemed rampant, our risk model held the fort and quietly predicted that volatility would calm down in a month. Our model predicted 13% volatility for U.S. equities. A month later, volatility was at 13%. Not bad!

Today, readings are still far away from systemic risk territory. In fact, the GARCH volatility term structure that we highlighted in our last updated has returned to normal.

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We also highlighted previously that the biggest risk would likely come from an earlier-than-expected rate hike by the Fed. As the Fed put things on hold in the last two months, markets also calmed down with volatility returning to normal levels, confirming our narrative.

This month we look deeper at when the market is expecting the rate hike. Despite constant promise by Yellen that a rate hike is firmly on the agenda, we believe that natural market forces is likely to prevent such a move. Should the Fed hike earlier than expected, volatility would likely return. So how do we scientifically measure market expectations?

Given that the Fed Funds rate cannot go lower than 0%, it’s impossible to see where the Fed Funds rate has been or where it’s going. Thankfully, researchers Wu and Xia had a major breakthrough last summer. They figured out a way to estimate where the fed funds rate is currently (even if it’s below zero) using forward rates. If these forward rates are simultaneously declining across the board, then the fed funds rate has likely declined as well!

We obtained the data for the Wu-Xia shadow rate, and show that the fed funds rate has been firmly negative since July 2009 and went as low as -3% in May 2014. Rates have been quietly on the rise ever since. It currently sits at -0.53% on October 30.

 

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Based on the speed the rate has risen, we can project that the first hike from 25bp to 50bp to happen as early as February or as late as June 2016, depending on how the economy evolves.

Is Christmas volatility ahead? Should the Fed decide to hike earlier than February 2016, markets would get anxious and volatility would likely return.



Build your practice on the backs of 3 Nobel prizes — Prospect Theory, MPT, and GARCH. 

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See what GARCH can do for you.
Build your practice on the backs of 3 Nobel prizes — Prospect Theory, MPT, and GARCH.