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By Jamie McGeever
LONDON, Feb 9 (Reuters) - Market seismographs are still twitching at levels almost twice the historical average and Wall Street's gauge of implied volatility needs to return below 20 percent for stocks to stabilise.
On the surface, Wall St's 8 percent drawdown in the last week is striking but hardly earth-shattering. The market is back to where it was only 10 weeks ago, which at the time was a record high.
But the surge in volatility that accompanied it was the highest on record, and the fall is far steeper and faster than the historical average.
The relationship between implied volatility and market moves is symbiotic, but it's not clear which drives which. Does low volatility push stocks higher, or does a rising market depress volatility?
Whatever the answer to that is, volatility is back and stock markets around the world are wobbling.
Not that policymakers are worrying about it. New York Fed president Bill Dudley said Wall Street's declines were "small potatoes" and ECB chief economist Peter Praet said: "I don't care. A big spike in volatility is fine, we can live with this."
Is the last week simply a long-overdue correction that paves the way for a resumption of the "melt up", or could it prove to be the point at which the "Goldilocks" view of buoyant stocks and permanently low volatility was shattered for good?
On a basic level, if volatility returns to low levels and remains well anchored, investors will be more likely to bid up stocks and other risky assets. Persistently high volatility will have the opposite effect.
Analysts at Goldman Sachs say it is still too early to call the end of the "low vol regime", a change that would fundamentally alter the balance of risks for investors.
"Whether volatility settles into a higher regime is critical to asset allocation from here and could still affect allocations from systematic investors," they wrote in a note this week.
Having spent over a year consistently below 20 percent, the VIX index of implied volatility one-month options on the S&P 500 surged above 50 percent this week. Tuesday's rise was the biggest since the index was first compiled 28 years ago.
The VIX, also known as the Wall Street's "fear index", was on course to close this week above 30 percent.
Goldman reckons the VIX below 15 percent is a "low vol" environment, and above 15 percent represents high vol. Others put the threshold at 20 percent. The median value of the VIX since its inception is 17.2.
In 1991-1996, the VIX was almost always below 20 percent. In those six years the S&P 500 rose around 140 percent.
The six and a half years from 1997 to mid-2003 was a higher vol regime, with the VIX almost always above 20 percent. The S&P 500 emerged from that period, which encompassed the Russian and Brazilian crises, Long Term Capital Management's implosion and the dotcom crash, about 30 percent higher.
The following four years, in which the Greenspan Fed embarked on a steady, gradual and telegraphed series of rate hikes, was a low vol era once again. Wall Street rose nearly 70 percent on its way to fresh record highs in October 2007.
The five years from mid-2007 to mid-2012 captured the global financial crisis. Unsurprisingly the VIX was mostly above 20 percent, although it had long spells around 2010-2011 below that threshold.
The market fell around 10 percent, but that period included the 60 percent crash over 2008 and into early 2009.
From mid-2012 to last month, the VIX was mostly back below 20 percent. It was anchored at record lows below 10 percent for much of last year although it did spike higher for much of the late 2015/early 2016 period.
Overall, though, that five-and-a-half-year period of low vol sowed the seeds for a rampant bull market. The S&P 500 doubled, setting dozens of record highs in recent months.
The pattern is clear: a consistently sub-20 percent VIX goes hand in glove with booming stocks, while a VIX consistently above 20 percent delivers very choppy market, meagre gains or slight losses.
Not to mention the risk of full-blown crash.
Reporting by Jamie McGeever; Graphics by Ritvik Carvalho; Editing by Larry King