Analysis-After lull, Wall Street eyes volatility pickup as risks build

By Saqib Iqbal Ahmed

NEW YORK (Reuters) -Wall Street is set to close one of its calmest quarters in nearly six years, and the lull after a volatile start to 2025 has many market participants increasingly alert for renewed market gyrations.

For the third quarter, the S&P 500’s one-month volatility – a gauge of the index’s monthly price swings – averaged 10.8, the lowest for any quarter since the three months ended December 2019.

The stock market has climbed relentlessly to record highs as investors boosted equity exposure after April’s tariff-related selloff, and Wall Street enjoyed a lack of new negative shocks. This crushed volatility. With the measure of market fear near historic lows, investors are growing wary that a spike could be close.

“There’s a natural floor for volatility. It doesn’t go to zero,” Matt Thompson co-portfolio manager at boutique investment firm Little Harbor Advisors, said.

“We know where we are in the larger volatility cycle, so the next move for volatility is almost guaranteed to be higher at some point,” he said.

On Monday, the S&P 500 and the tech-heavy Nasdaq composite index both closed not far from the respective record highs.

HISTORICAL LOW

Historically, volatility at these low levels tends to persist for weeks rather than months. Extended calm has often been followed by sharp spikes, including at the end of the fourth quarter of 2019 just before the pandemic market crash and the third quarter of 2018 when stocks sold off amid concerns about trade and economic growth.

For now, optimism around large-cap stocks tied to artificial intelligence and confidence in the resilience of the U.S. economy continue to support investors’ appetite for taking risk in equities.

Still plenty of catalysts could spark volatility: A potential government shutdown could disrupt a wide range of services as soon as Wednesday. Investors also await economic data that will inform the path of interest rates.

With macro risks elevated, a shock on the scale of August 2024 due to the yen carry trade unwind or April 2025’s tariff scare would likely inflict greater losses on investors betting on continued calm than any gains from an extension in the current lull in stock swings, Rocky Fishman, founder of Asym 500, a firm that provides data and analytics on the options market, said in a note on Friday.

Indeed, Cboe data showed some pick-up in demand for protection last week, with three-month skew – a gauge of demand for insurance against a market drop over the next three months – rising the most versus other tenors.

RISKS ABOUND

A pick-up in volatility could spark selling by systematic strategies – rules-based funds that use volatility and momentum signals to drive buying or selling decisions.

The collapse in market gyrations has driven these types of strategies to raise their equity allocations to historically high levels. According to Deutsche Bank estimates, a jump in volatility could see them turn sellers of equities.

Deutsche Bank strategist Parag Thatte estimated such strategies command about $1 to $1.5 trillion in assets, enough to at times amplify market moves even if they are not huge in size relative to the overall equity market.

“They don’t start the moves but their impact can be a lot higher than one would expect given their size,” Thatte said.

Still, for many investors the recent low volatility is not reason enough to pull the trigger on hedges that can still prove to be expensive if market calm persists.

Little Harbor Advisors’ Thompson is content to trim equity exposure rather than buy downside protection, as he waits for more confirmation that market volatility is set to rise, he said.

Others advocate taking advantage of the market calm to pick up hedges to complement risk-on positions.

“For those who are all-in to the AI-driven FOMO rally, I really think the low volatility levels do allow for protection,” said Tobias Hekster, co-CIO at True Partner Capital, using a market acronym for “fear of missing out.” True Partner Capital is a global asset management firm specializing in equity volatility strategies.

“One can stay with the herd, but have a parachute when the music stops,” he said.

(Reporting by Saqib Iqbal Ahmed; Additional reporting by Laura Matthews; Editing by Alden Bentley and David Gregorio)