Event risk has remained notably elevated since late February, driven largely by the conflict in the Middle East and an increasingly unpredictable policy backdrop from the US. However, this does not appear to be reflected in implied or realized volatility. Markets continue to exhibit a remarkable degree of calm, whether measured through volatility indices, total returns, or credit spreads.
A possible explanation lies with investor behavior. The narrative around the Iran conflict changes constantly and often abruptly, leaving market participants to effectively abandon attempts to anticipate geopolitical outcomes. Rather than constantly repositioning portfolios in response to conflicting signals, investors appear to have chosen to remain anchored to benchmark weights. And this appears to be the case for both long-only and absolute return investors. COR1M, a measure of S&P 500 implied correlation, surged from roughly 15 at the end of February to over 40 by late March, suggesting a diversification breakdown.
What could force markets out of neutral?
What might break investors from this increasingly passive stance? Markets remain trapped in a limbo state where risks are significant but outcomes remain uncertain. Investors could be forced into more decisive positioning under either of two scenarios.
The first would be a dramatic escalation of the conflict in Iran that results in boots on the ground. Such a development would likely trigger a sharp repricing across asset classes, with volatility moving substantially higher as investors rush to hedge risk.
The alternative scenario involves a lasting and credible resolution of tensions. A reduction in geopolitical uncertainty would allow investors to move away from neutral positioning with greater confidence, enabling capital to be redeployed based on fundamental rather than geopolitical considerations.
The front end remains the primary driver
Following the failure of the US-Iran Memorandum of Understanding (MoU), the front end of the curve is once again being repriced. The broad pattern across rates markets remains intact, with movements in short-term yields continuing to be more pronounced than those at the long end of the curve.
In this environment, front-end rates continue to dominate curve dynamics, reflecting investor sensitivity to policy expectations and uncertainty around future economic outcomes.
A unique combination
Markets have experienced periods of geopolitical uncertainty alongside subdued volatility before. However, the current combination of unresolved risks and extremely contained volatility is unusual. By most conventional standards, the level of geopolitical uncertainty embedded in headlines would typically be associated with significantly wider risk premiums.
The divergence becomes particularly evident when examining the relationship between oil and credit markets.
During February and March, Brent crude and the iTraxx Europe Main Index (a major credit default swap benchmark that tracks 125 liquid, investment-grade European corporate entities) moved largely in tandem. Brent rallied sharply from approximately $60 per barrel to a peak near $118, while the index widened from roughly 50 basis points (bps) to about 73bps. This reflected a conventional risk-off response, with higher energy prices coinciding with wider credit spreads.
From April onwards, however, the relationship began to break down. The Brent crude price retraced part of its rally, but credit spreads tightened far more aggressively. In effect, credit markets have reversed a greater share of their earlier risk repricing than the oil price has given back from its prior rally, suggesting investors have become increasingly comfortable looking through geopolitical risks.
Equity volatility tells a similar story. The VIX volatility index has drifted back towards its five-year median of 17.89. It points to a remarkably contained risk premium despite elevated energy price volatility, persistent geopolitical uncertainty, and the effective dismantling of the US-Iran MoU framework.
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