Central banks tightening is supportive of risk appetite but historically a large shock such as a war or recession has been required to snap low market volatility, according to strategists at Goldman Sachs.
The low volatility "regime" currently plaguing the equity market is comparable to the last 14 cases since 1928, strategists Christian Mueller-Glissmann and Alessio Rizzi said in a research note published Monday. These periods tend to last almost two years with short-lived spikes and S&P 500 volatility around 10.
"Historically, volatility spikes have been hard to predict as they often occur after unpredictable major geopolitical events, such as wars and terror attacks, or adverse economic financial shocks and so-called 'unknown unknowns' (e.g. Black Monday in 1987)," London-based strategists said in a note.
"Recessions and a slowing business cycle have historically resulted in a high volatility regime across assets," they added.
The CBOE Volatility Index (.VIX), considered the best gauge of fear in the market, slumped to 9.37 last month – its lowest level in more than 24 years. On Tuesday, the index inched slightly higher to 11.22.
Investors are seen positioning for higher volatility, partly in reaction to hawkish signals from several major central banks, the analysts said. However, while the low volatility regime is likely to be tested, a sustained breakout is not forecast to succeed.
"Breaking out of the low volatility regime usually required a large shock, for example, a recession or war. While central bank uncertainty can drive volatility in the near term, it is unlikely to drive a sustained high volatility regime," they said.
Goldman explained that while periods of low volatility are not necessarily unusual, they tend to emanate from a robust macroeconomic backdrop with strong growth and relatively low inflation and interest rates – similar to a "Goldilocks" scenario. Financial markets have reflected this since the start of the year, they said.
The investment bank estimated the chances of a recession over the next two years at 25 percent.