If you consume financial news regularly, you must have noticed that on any given session, major stock indexes can swing wildly. Take, for example, the Dow Jones Industrial Average, or just the Dow, in Monday’s February 9 session. The Dow opened almost unchanged from Friday’s 50,047 level. And in 20 minutes, the index had shed about 165 points, that is a 0.32% decline. It took one hour for the index to recover to a new historical high of 50,200 at 10:40 a.m. (GMT-5).
Whatever you think of the fluctuations, they are not random. That is to say that markets always move for a reason, even when there is no major development in the news cycle to justify the movement. In other words, there are subtle forces that drive price swings, and these are the subject of today’s newsletter.
First, What Is Volatility?
When the Dow’s price collapses and then pares the losses just minutes later, that is volatility. To put it simply, volatility measures how much and how quickly an asset moves up and down the price ladder.
Academics found that they can use this phenomenon to measure uncertainty in the market. They concluded that there is a lot of uncertainty when prices swing wildly and that the opposite points to steadiness in the market. And then the Cboe Global Markets created the Cboe Volatility Index (VIX) to help market participants and observers quantify the level of stress, fear, or confidence among investors. That is why many call it the fear index or the fear gauge. CNN has its version that it calls the Fear and Greed Index.
So, What Are the Hidden Drivers of Volatility?
The truth is, only a few of these drivers are permanent. Some can come and go and others only appear once and disappear forever.
A great example of a volatility driver in the current environment that may never reappear in the future is the crowded artificial-intelligence positioning. For sure, the technology itself is a permanent structural shift. In fact, Wedbush Securities’ Dan Ives told CNBC last year that AI infrastructure development is the foundation for the fourth Industrial Revolution. Be that as it may, analysts describe the current concentration of capital into a few “AI darlings” as a temporary market distortion that periodically resets
One of the hidden volatility drivers that will always be there, no matter the season is the drift in expectations. As we have repeatedly noted in previous newsletters, markets are prediction machines. Simply put, price movements expose how traders adjust their forecasts for future outcomes.
When, say, expectations for interest rates or inflation or economic growth shift slightly, even when there is no new data release, the market can reprice assets meaningfully. A great example is when traders tweak expectations for monetary policy based on subtle clues from Fed officials or asset yields. Although these adjustments may travel through the market quietly, they certainly carry palpable weight.
So, unlike headline news, these expectation drifts happen under the radar. And only forward-looking instruments like options pricing or interest rate futures can capture them.
Another hidden volatility driver that can be described as a constant is when liquidity vanishes. According to Maureen O’Hara of Cornell, modern liquidity is fleeting. In her research on high-frequency market microstructure, O’Hara explained that high-frequency traders (HFTs) supply liquidity “but unlike traditional market makers, there is no commitment to provide liquidity continuously.” And so when volatility spikes, these algorithms withdraw, creating transitory volatility. That is, price swings caused not by fundamental revaluation, but by the temporary absence of buyers.
The Bank for International Settlements, or BIS, in their August 2024 bulletin, confirmed this line of argument. The BIS noted that as the Japanese yen surged in that month, forced liquidations triggered margin calls across global markets. And as a consequence, the Japan Securities Clearing Corporation hiked initial margins by 60-80%, and HFT systems throttled back. The result was a liquidity vacuum: the same order flow that might move markets 0.5% on a normal day generated 3% swings because “the sudden withdrawal of liquidity led to a rapid repricing,” as M&G Investments observed.
Bottom Line
Daily market volatility happens because there is a catalyst driving it. You may not see it but it is happening. So, if the fear gauge suddenly spikes and nothing in the news cycle provides a hint, the market is most likely being affected by subtle forces. That is why it is a good idea to monitor the VIX term structure for stress and track Treasury bid-ask spreads for liquidity withdrawal.
