Outlook 2010: Volatility hard to predict, seen as wildcard in 2010

By Rebecca Melvin

New York, Dec. 31 - The VIX is easy to predict but impossible to get right. Volatility itself will be volatile, a New York-based buyside portfolio manager said.

Other sources were also reluctant to take a stab on where volatility will be in 2010, calling it the quintessential wildcard.

Volatility is inversely related to equity prices and credit spreads, and tends to be mean-reverting.

"If you look at the VIX over a market cycle, it looks like we are right around the mean now. Which direction we go from here will depend on stocks, credit spreads, and the macro environment, among other things, a sellsider said.

Although the Bank of America Merrill Lynch equity derivatives team expects S&P 500 three-month realized volatility to drop to about 14% to 19% in 2010, from about 23% at the end of November, other sources said high volatility will continue to be favorable for convertibles, especially early in the year.

"I think you're going to see a pullback, with some kind of a correction in the marketplace. I think the Christmas season will be weak, housing will remain weak - we've come too far, too fast," a Connecticut-based sellsider said. And the volatility will work in favor of convertibles.

Using four different scenarios as the basis for Bank of America Merrill Lynch's 2010 predictions, analyst Tatyana Hube has volatility ranging from 15% to 30%.

An optimistic economic scenario puts volatility at 15%, with the S&P 500 up 25% for the year, two-year Treasuries rising to 2% and high-yield spreads tightening by 50 basis points.

A double-dip recession scenario puts market volatility at 30%, up 10 points, with the S&P 500 down 15%, two-year Treasuries decreasing to 0.7% and high-yield spreads widening by 150 bps.

Hube's base case scenario is for volatility measured by VIX to be down 3.5 points to 17%.

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