(The opinions expressed here are those of the author, a columnist for Reuters.)
By Jamie McGeever
LONDON, May 31 (Reuters) - The panic in Italian bonds this week again exposed the risks associated with periods of unusually low market volatility that lure traders into leveraged bets on the calm persisting forever - and magnifying the blowout when uncertainty rears its head again.
Sudden bursts of volatility and evaporating liquidity in even some of the world's most-traded instruments is a dangerous cocktail for traders and hedge funds caught on the wrong side when the explosion comes. But investors should get used to it.
This is the second such explosion this year of trading strategies that hinged on general financial volatility remaining low. As bond yields crept higher in early February, so-called 'inverse Vix' trades that profited from continued narrow movements in the S&P500 stock index suddenly imploded and sent shockwaves across world markets.
Andrew Balls, chief investment officer for global fixed income at Pimco, the California-based $1.8 trillion asset manager, warns that a weakening of the already peculiarly long economic cycle and central banks withdrawing post-crisis stimulus will push up volatility from historically low levels in the months and years ahead.
"Wanting to sell volatility in our portfolios has been a key strategy for us for more than 20 years. But we will be more cautious in terms of selling volatility," Balls said this week in London.
"We may even find opportunities where it makes sense to buy volatility, which used to be something we would rule out 100 percent. But now, there may be opportunities where it makes sense to be long volatility," he said.
Trading strategies built around low volatility have been a huge cash-generator for investors since the crisis because the world's major central banks have suppressed volatility with trillions of dollars worth of bond-buying stimulus.
Few traders or investors had the nerve, patience and pockets deep enough to bet against the central banks, so yields, spreads and volatility were compressed. To do so would risk getting steamrollered by the Fed, ECB and others.
For most of the past five years the two-year Italian/German spread was under 100 bps, falling to just 25 bps earlier this year. The 10-year spread narrowed to 115 bps in April.
Traders and investors assumed that the ECB's massive bond-buying stimulus would keep yields and spreads suppressed. The only way to make money on what seemed like a racing one-way bet was to leverage up and keep on rolling over the position.
But the danger is everyone has the same position, and when the market turns, the tide of liquidity moves out extremely fast. Everyone is exposed and forced to run for cover, shattering the illusion of liquidity.
Market episodes like these have been amplified enormously in recent years by the proliferation of computer- and algorithmic-driven trading and exchange-traded funds.
It was Italian bonds this week. On Tuesday two-year yield shot up 154 basis points on the country's deepening political crisis, the biggest rise since 1992. Two days later, it fell 100 bps, the biggest fall since 1996.
Volatility of that magnitude would test even the most risk-hungry hedge fund, never mind the average investment or mutual fund with conservative mandates designed to protect them from potentially devastating wild market swings.
What's alarming here is this is one of the most liquid of all markets. There's no shortage of cash sloshing around Italian bonds - with 2.26 trillion euros of debt outstanding, it's the third largest sovereign debt market in the world.
These episodes are becoming more frequent. On top of February's 'volmageddon' the Swiss franc, sterling and U.S. Treasuries have been hit by similar turbulence in recent years.
And that's not taking into account the market meltdowns in emerging countries, which are more commonplace anyway, like those in Russia, Turkey and Argentina.
The 48-hour round trip in Italian bonds this week shows what happens when volatility shoots up and liquidity disappears. It's the type of rollercoaster ride investors should get used to.
Reporting by Jamie McGeever Editing by Hugh Lawson