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All macro traders and most asset managers I know still believe they are living in a precarious risk-on, risk-off world. Their hard-won gains from clever carry trades or high-alpha stock picks can get washed out in an instant by a surprise statement from an equivocating Eurocrat or a belligerent ayatollah. They assume that RORO, as this phenomenon of highly correlated asset markets is known, is now an inescapable fact of life on the trading floor, an unpleasant yet persistent trend like global warming or reality TV.

Yet all macro traders know that implied volatility is trending down, in a series of successively lower waves of the VIX, the Chicago Board Options Exchange index of volatility in options prices on stocks in the S&P 500 index, since its peak in 2009. They also have the impression that markets are shrugging off bouts of volatility more quickly, but they’re not sure they trust this apparent reversion to stability.

“I’m anxious that the new normal may turn out to be a walk in a dark labyrinth,” says Mark Farrington, head of London-based Macro Currency Group, the currency specialist arm of U.S.-based Principal Global Investors. “On the surface the data suggest an ebb in volatility indicators and even a respite in risk-on, risk-off market conditions. But our research suggests that the true underlying risk to portfolios is not accurately reflected in the implied market volatility indexes.”

Have the political factors that drive financial markets changed in some fundamental way in recent years to produce this unnerving pattern of reduced volatility with elevated RORO, or have the markets themselves changed? The question has far-reaching implications for traders and investors around the world. As Farrington puts it, “We may be looking at a discontinuous structural change in the connection between political events and market outcomes.”

To examine the issue, let’s start with what we know.

The risk-on, risk-off nature of markets, as measured by asset cross-correlation, has been climbing a jagged mountain since hitting a low point in 2005. Notwithstanding a recent dip, cross-correlations have doubled over the past two decades.

Analysts at HSBC Holdings were so convinced that risk-on, risk-off has become a new structural reality that they constructed the RORO Index, which measures the variance in daily returns of 34 asset categories, to track it. “Correlations between asset classes appear to be on a long-term upward trend,” they explained in a November 2010 research note. “This suggests a structural change could be taking place in markets.”

That view is shared by Marko Kolanovic, an equity derivatives strategist at J.P. Morgan in New York. “Cross-asset correlation declined by approximately 20 percent over the past three months,” he says. “But we believe cross-asset correlations will not decline further and are more likely to increase from these levels.”

In contrast to RORO’s upward climb, the big waves of market volatility that peaked in late 2008, shortly after the collapse of Lehman Brothers Holdings, have been ebbing ever since. The VIX, the benchmark of equity market volatility, hit a record-high close of just over 80 in November 2008 and hasn’t come close to that level during subsequent flare-ups. The last notable surge, during the euro crisis in mid-2011, topped out at less than 50. The VIX hasn’t broken above 20 so far in 2013.

As for mean reversion, there is a lot of anecdotal evidence that markets are shrugging off volatility and risk upticks. “One of the older mantras of trading has been to ‘sell the news,’ meaning that most ‘new’ information is already contained in the current price of a given instrument. This news may be central bank actions (or inactions), data releases, earning announcements (hits or misses) and the like,” says David Leibowitz, London-based Prologue Capital’s senior portfolio manager in Greenwich, Connecticut. “Major surprises can be market-moving events, but not always. The Boston Marathon terrorism amplified an already weak stock market, causing an additional 1 percent sell-off from 3 p.m. to 5 p.m. on April 15, 2013. Yet even that shock was unwound by the New York opening the following day.”

The statistics support that impression of more-unflappable markets. The number of trading days required for mean reversion of volatility peaked in 2007–’08 and has fallen since then, repeating a pattern seen in data going back to 1900, according to Elroy Dimson, Paul Marsh and Mike Staunton of London Business School. It took nearly 250 trading days for volatility to return to the mean after the collapse of Lehman Brothers, the economists point out in the recently published “Credit Suisse Global Investment Returns Sourcebook.” By contrast, it took 98 days after Greece set off the euro area debt crisis in 2010 for volatility to revert to its mean. The average mean reversion time for 11 major episodes of market turbulence, dating back to the 1987 stock market crash, was 106 days.

“The empirical evidence over 113 years indicates that, when markets are turbulent, volatility tends to revert rapidly to the mean, so that we should expect any period of extreme volatility to be relatively brief, elevating the expected equity premium only over the short term,” the economists write.

Is this apparent increase in RORO, decrease in volatility and faster mean reversion a result of something different about recent events? Are these events larger or more surprising than before? Or does it reflect something new in the way financial markets react to events?

For those who believe that politics holds the answer, there are three major “sovereigns rule” explanations. First, governments are interfering in markets more, with fiscal expenditure taking up a larger percentage of gross domestic product, more-intrusive regulations and increasingly feckless politicians — and all of this increases economic policy uncertainty. Second, systemic risk caused by a combination of ineffective sovereigns and poor prudential regulation lingers in the global financial system. Third, central banks continue to flood markets with liquidity, in part to fund their sovereigns, in part to spur macroeconomic recovery and in part to keep the financial markets themselves from seizing up.

On the other hand, there are three potential “markets rule” explanations: Markets are more efficient in terms of relative pricing, traders are getting more cautious, or traders are getting desensitized by the torrent of data that crosses their terminals.

Let’s examine the six explanations for higher RORO, lower volatility and faster mean reversion and see how they stack up against the evidence.

ONE CONVENTIONAL EXPLANATION FOR the “sovereigns rule” thesis is the expanded role of governments in the global economy and the uncertainty generated by the fact that their decisions are subject to an inherently messy political process. “The extraordinary turn of events in the euro zone over the past three years highlighted that politics has been driving financial markets, making it harder to invest in these countries,” says Wolfango Piccoli, head of Europe at Teneo Intelligence, a political advisory firm. (The author is CEO of   Teneo Intelligence.) “Country and company fundamentals have been often sidelined while markets have reacted to the more-often-than-not unwise statements by euro zone politicians.”

In what specific ways could governments be affecting markets? Some participants stress the secular expansion of government budgets, others cite more-intrusive (and uncertain) regulations, and a third group points to increasing (and unpredictable) taxation.

Government expenditures rose at a consistent pace in the 1970s and ’80s in countries of the Organization for Economic Cooperation and Development, but there was no sharp inflection point during the mid-1990s that would explain a big increase in market volatility. Total government outlays averaged about 40 percent of GDP in the OECD from the 1990s to 2007, according to Oxford Analytica, with euro area countries averaging about 47 to 48 percent and the U.S. 36 to 37 percent. The financial crisis led to a steep change. “The recession forced spending up and so by 2010 the outlay ratio stood at close to 45 percent of GDP for the OECD, over 51 percent in the euro area and between 42 and 43 percent in the United States,” the political and economic analysis firm wrote in a recent daily briefing note.

There are similar trends in increased regulation, particularly among European members of the OECD, but this growth has also been relatively consistent. The most obvious recent regulatory trend is tax regulation, in response to governments’ sustained structural deficits and to so-called tax-venue shopping and other avoidance tactics. The European tax commissioner— did you know they had one? — contends that tax avoidance costs euro zone governments €1 trillion ($1.3 trillion) a year in lost revenue. The official, Algirdas Sˇ  emeta, has been pushing a series of measures on bank transparency to track down those missing funds.

Skeptics argue that long-term secular increases in government expenditure, deficits, regulation and even taxation can’t explain increases in financial market volatility unless there is a surprise factor at work. Otherwise markets will simply price in these economic effects for good or for ill.

A trio of economists — Scott Baker and Nicholas Bloom of Stanford University and Stephen Davis of the University of Chicago Booth School of Business — recently started a line of research exploring the surprise factor. They crafted an Economic Policy Uncertainty Index for the U.S. by combining newspaper references of uncertainty in government policy with the number of unexpired tax codes and the variation in economists’ forecasts for government spending and the consumer price index. The EPU index trended mostly lower from 1985 to 2007 except for a few spikes above the 150 level around the 1987 stock market crash, the first Gulf  War, the crisis at Long-Term Capital Management, the 9/11 terrorist attacks and the invasion of Iraq. The global financial crisis pushed the index sharply higher. It soared above 150 at the time of the Lehman Brothers collapse and President Obama’s 2008 election victory and has rarely fallen below 150 since then. The index surged well above 200 during the height of the euro zone crisis, in the summer of 2012.

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