Low Volatility Echoing Pre-Recession Making Investors Nervous

Bonds, stocks and currencies are approaching all-time lows in trailing one-month volatility. Stability would usually please investors (options traders excluded), but instead we are reminded of the lull in volatility in the two years preceding the Great Recession of 2008. Anecdotally, the yield on the 10-year Treasury note has been in the range of 2.48% to 3.03% since the beginning of the year. In the past month, the range has tightened even further, to 2.48% to 2.72%. By definition, all else equal, risk-adjusted returns improve when volatility is low, but there can be adverse consequences. The perception of low volatility can result in a re-pricing of risk. In the case of bonds, this means a tightening of credit spreads as investors demand less compensation for riskiness. Lower spreads entice individuals and corporations to borrow more. In effect, low volatility increases risk taking. In this way, some argue the “Great Moderation” set the stage for the Crisis of 2008. From a credit analysis perspective, we do see evidence of an increase in corporate borrowing as CFOs take advantage of low interest rates. At the same time, corporations, especially banks, are holding more cash than ever. Economic projections are completely the opposite of those we saw going in to 2008, jobs are being created and growth appears just around the corner. A little extra risk-taking in this environment is most likely warranted.