(Bloomberg Opinion) -- Few words strike fear in the hearts of investors like “volatility.” It's a euphemism for markets that have somehow gotten out of control. And right now, it seems as if all markets — stocks, bonds, commodities, currencies — are anything but under control. “The volatility of everything is spiking,” Jason Goepfert, president of Sundial Capital Research Inc., wrote in a report on Monday. “That's an incredible bout of cross-asset concern that we've rarely seen in the past 30 years.”
Indeed, as Bloomberg News's Joanna Ossinger and Lu Wang report, the Cboe Volatility Index, or VIX, which measures price swings in equities, has risen to its highest since early 2021, while gauges measuring fluctuations in options tied to U.S. Treasury securities and foreign-exchange rates have reached levels not seen since the peak of Covid-19 uncertainty in early 2020.
It's impossible to know whether such conditions will ease soon. But what is becoming increasingly clear is that rising volatility is a consequence of authorities trying to make the banking system safer after the financial crisis that played out over 2007 and 2008 and led to the collapse of storied institutions such as Lehman Brothers Holding Inc. and Bear Stearns Cos. The banking system had become so stressed at the time that it came within days, perhaps even hours, of seizing to the point where ATMs might not have been able to spit out cash on demand.
What came next were reforms — the Volcker Rule, the Dodd-Frank Act, Basel III — that forced most big banks to cut back on proprietary trading and keep a sizable portion of their reserves in the safest assets. That's one reason Federal Reserve data show deposits at U.S. banking institutions alone exceed loans — a measure of surplus liquidity — by $7.33 trillion. That's up from about $250 billion in 2008.
That's the reassuring part. What's not so reassuring is the disconnect between the growth in financial markets over the past decade because of ultra-easy monetary policies and the capacity of banks to take on risk, which may be exacerbating the current bout of higher-than-normal volatility across markets. Consider that the total market value of stocks worldwide grew to a peak of $122.5 trillion in November 2021 from about $50 trillion in 2007, according to data compiled by Bloomberg. Or that the total amount of debt worldwide expanded to $303 trillion at the end of last year from about $200 trillion a decade ago, according to the Institute of International Finance.
So while the role of traditional Wall Street banks in global markets has diminished, that of loosely regulated hedge funds has increased. Assets under management at global hedge funds topped $4 trillion for the first time ever at the end of 2021, according to Hedge Fund Research. At one point last year, the strategists at JPMorgan Chase & Co. estimated that the amount of leverage in use at hedge funds — 1.5 times — had reached a level not seen since just before the collapse of Lehman Brothers. To be sure, they said it was still “significantly below” the historically high levels of about 2.25 times seen around the Long-Term Capital Management crisis in 1998 (which just happened to stem from Russia defaulting on some of its debt).
The good news is that markets have weathered plenty of periods of elevated volatility in recent years. Some of those include the European debt crisis a decade ago, China's botched currency devaluation in 2015, the Brexit referendum in 2016, the “Volmageddon” episode in February 2018, the Covid-19 pandemic and the collapse of Bill Hwang's $100 billion hedge fund Archegos Capital Management.
All those events, however, came during periods of relative calm and accommodative central bank policies. It's not that way now. Russia has invaded Ukraine and made veiled threats of using nuclear arms if the West intercedes. Inflation rates worldwide are soaring, reaching the highest in the U.S. since the early 1980s. Energy prices have leaped to record levels. Global food prices are rising rapidly, which has led to civil unrest in the past. And central banks are being forced to raise interest rates from zero and withdraw liquidity from financial markets to counter inflation despite a slowing global economy. Just this week, the strategists at JPMorgan slashed their estimate for how fast the world's economy will grow in the first half of this year to a 2.6% annual rate from the 4.9% they forecast just three weeks ago.
It's impossible to know where this latest bout of elevated market volatility will lead, when it will end or whether it will pass without causing a financial crisis. But what we do know from history is that disruptions in one asset class often impact others, creating a domino effect that leads investors to cut back on risk, causing liquidity to erode in even the safest of assets such as U.S. Treasuries, which is when bad things often start to happen.
For now, interbank lending rates are rising but nowhere near levels that would indicate excess stress inside lenders, and credit-default swaps tied to the debt of banks are calm. But that may be just false reassurance given that many of the risks once held by banks have been transferred to less regulated and more opaque corners of the markets — risks that were largely contained thanks to a benign economic environment marked by low inflation, accommodative central banks and relative calm on the geopolitical front that may be disappearing.
More From Other Writers at Bloomberg Opinion:
- This Is No Century for Optimists. Can It Change?: John Authers
- Money Markets Pass Their Stress Test — For Now: Marcus Ashworth
- Emerging Markets Are Canaries in Credit Mines: Richard Cookson
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Robert Burgess is the executive editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company's news coverage of credit markets during the global financial crisis.
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