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INVESTMENT FOCUS-Economic reversal, not politics, will reignite market volatility

| LONDON

LONDON May 12 Financial market volatility has slumped to historic lows despite a world full of political and policy uncertainty, a phenomenon investors expect will remain until the business cycle turns and economic growth falters.

Such ultra-low volatility worries investors because the last times it was so low -- in 1993-94 and 2006-07 -- major market dislocations soon followed, respectively, the U.S. bond market rout of 1994 and the global financial crisis of 2008.

This time, volatility has been crushed despite the proliferation of political risks from the global rise of nativism and protectionism, Brexit, and the election of U.S. President Donald Trump, all of which were meant to undermine market stability.

But they haven't. Record low interest rates and central bank stimulus around the world have suppressed returns, pushing usually cautious investors like pension and mutual funds to hold more equities than they normally would.

This has depressed actual volatility, limiting implied volatility.

Riskier assets like stocks have continued to gain, spreads have narrowed, and nearly all measures of volatility have declined further, largely because economic activity, growth and corporate profits have weathered the storm and held up well.

It could go on for months, or even longer, until growth deteriorates. And that will happen when credit, lending and hiring growth slows, finally turning what is already the third longest U.S. economic expansion in history, analysts say.

According to JP Morgan, the level of global economic volatility is currently its lowest in over 40 years. The tricky bit is predicting what triggers the turnaround, and when.

Much of the focus is the VIX 'fear index' of volatility on the S&P 500.

"As ever, it all comes down to one thing – the business cycle. The VIX is not going to rise significantly until the business cycle weakens, nor is the generalised level of volatility," Raoul Pal, an independent investment strategist and founder of Global Macro Investor.

Pal points to the close correlation between the ISM U.S. purchasing managers index, a leading indicator of business activity and growth, and a range of market volatility indices, including the VIX.

He and others say that market participants are always implicitly "short" volatility before a recession. That's when optimism is highest, borrowing is most stretched, and "long" positions in risky assets like equities are the most crowded.

LOWER ... BUT FOR HOW MUCH LONGER?

Torsten Slok, a managing director at Deutsche Bank in New York, notes that an investor "shorting" the VIX a year ago -- betting that it would fall -- would have gained around 160 percent today. Conversely, an investor going "long" or buying the VIX would have lost 75 percent.

Researchers at the Bank for International Settlements in Switzerland say the VIX is no longer an accurate barometer of wider market risk.

David Hait, chief executive and founder of research firm OptionMetrics, reckons a whopping 98.8 percent of daily changes in the VIX is due to previous VIX values and current S&P 500 returns rather than the future volatility it is supposed to gauge.

Implied and actual volatility can quickly become entwined in a spiral lower because investors are less inclined to pay up for "put" options -- effectively a bet on prices falling -- when the market is rising. Complacency sets in.

"The lower the VIX goes, the more vulnerable the global financial system gets to any kind of shock. This is quite worrying," said Deutsche Bank's Slok.

The VIX has closed below 11.00 for a record 14 days in a row. And the S&P 500 this week recorded a run of 11 out of 12 trading sessions with a daily close of less than +/- 0.2 percent, a period of stability not seen since 1927, according to Deutsche Bank.

Jonathan Tepper, co-founder of Variant Perception Research, says the two best long-term predictors of volatility are the credit cycle and economic volatility.

"High leverage always leads to higher volatility as the credit cycle matures. And we've been levering up for the past eight years since the 2008-09 recession," he said.

Tepper draws similarities with today and 1993-94 when the Federal Reserve was also hiking interest rates, and late 2006/early 2007 before the financial crisis when companies' borrowing levels were highly stretched.

The Fed's rate hikes of 1993-94 pushed the 10-year yield up to nearly 8 percent from 5 percent over the course of 1994. The VIX more than doubled early that year before drifting back again.

There was no recession though, in large part because corporate borrowing was relatively low. This meant companies were better equipped to cope with the rise in borrowing costs.

That wasn't the case in 2006-07 when commercial and industrial loans as a share of the overall economy was on its way above 10 percent, a level associated with recession. That's exactly what followed, and volatility exploded to record highs.

Few are anticipating another great financial crisis. Equally, few expect volatility to remain so low for ever.

"Recent data, such as the ISM, suggest the (growth) acceleration phase may be behind us. Coupled with policy and political uncertainty, this could drive a more sustained increase in equity volatility in the coming months," Goldman Sachs market strategists said in a recent note to clients.

(Editing by Jeremy Gaunt)

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