Equity volatility: 2024 outlook

Stock market volatility in 2023 has trended downwards, although with fluctuations throughout the year. The VIX index surged in the first quarter but declined rapidly thereafter. Volatility rebounded during the summer due to a surge in long-term interest rates but declined again on rising hopes for rate cuts.

The US Federal Reserve has aggressively increased interest rates since March 2022. Despite this, corporate profitability has remained strong, thanks in part to government support and the long period of low rates before March 2022. The housing sector has also shown resilience because of low adjustable-rate mortgages. However, monetary tightening is eventually expected to catch up on corporate profits, potentially causing financing challenges for weaker companies. Indeed we anticipate that the full impact of high interest rates will be felt from the second half of 2024 onwards. 

All things considered, our fundamental volatility model, which is based on the lagged effect of interest rates on realised volatility on the S&P 500, suggests a decline in volatility during the first half of next year, followed by a gradual increase in the second half. Unless a severe recession occurs, we expect volatility to be in a medium-to-low range in the first half of 2024 and a medium-to-high range in the second half. However, our model does not account for short-term risks such as data surprises or unpredictable external shocks. These could keep volatility higher than what the model implies in the first half of the year. There is, for example, the possibility of an upside surprise in inflation, which could compel the Fed to raise interest rates again or maintain them at high levels for longer than the market is expecting. 

We do not believe the flow of funds into volatility strategies will have a significant impact on volatility trends in 2024. The combination of high interest rates and the current low volatility makes short volatility strategies unappealing. Consequently, we do not think the drop in the VIX index below 12 is sustainable. The volume of zero-dated (ODTE) options has doubled in 2023, but these should have a limited impact on the S&P 500’s volatility as buy and sell flows remain in balance.