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Meteorologists expect this year’s Atlantic hurricane season will pass with relatively few intense storms. Will the same apply to financial markets?

Recent exceptionally low volatility in global equity, bond and foreign exchange markets may appear to many investors as the lull before a severe event. With the US and Europe entering the holiday season, when financial upsets often happen, the Vix index of US share price volatility, or “Wall Street fear gauge,” remains near seven-year lows.

Of course, the calm may have little significance; volatility could revert to more normal levels – perhaps later this year when the US Federal Reserve completes the unwinding, or “tapering,” of its quantitative easing programmes. History also shows that periods of market calm can be protracted. Alternatively, as during the build up to hurricanes, the current calm could mask pressures building beneath the surface that eventually create a force capable of wrecking havoc across large areas.

The problem is that the science of predicting financial storms is under-developed. That is perhaps odd. Like hurricanes, market crashes are regular occurrences. They are also the result of complex systems producing freak outcomes. In the case of Atlantic hurricanes, the trigger can be weather patterns elsewhere in the world. In markets, it can be miscalculations by a financial institution or a change in sentiment towards an asset class.

Complacency danger

Academics are trying to fill the void. The latest attempt to model financial systems that have outgrown modern economies was unveiled last week in a paper for the Review of Financial Studies by Paul Woolley of the London School of Economics and colleagues from the universities of Zurich and Toulouse.

They argue that in good times investment managers’ confidence rises and financial innovation flourishes. But risk prevention and prudent valuation process are costly, and dispensed with by managers who “shirk”. When information is “asymmetric” – you do not know who the responsible managers are – the vulnerability of the financial system to shocks increases, the paper argues.

Their model is relevant because the dangers are greatest when complacency is highest. And central banks’ grip over markets has arguably pushed complacency to new peaks.

Complacency is also higher in holiday seasons, which might explain the prevalence of market turmoil in summer months. But explaining when – rather than just why – financial systems will crash is perhaps a task better suited for mathematicians or physicists.

Financial markets are interesting test cases for those who model extreme events in complex systems. While economists talk of the arrival of “black swans” – things that are rarely seen – physicists (who probably play more fantasy computer games) talk of ominous “dragon kings”, statistical outliers created in exceptional circumstances.

One pioneer in this field, Neil Johnson, professor of physics at the University of Miami, argues that predicting financial crises should become possible. The processes that lead to “dragon kings” are deterministic – rather than the result of chance or human folly. Like in weather forecasting, complete information is not required, just sufficient data samples.

Superficial calm

As with hurricanes, Professor Johnson finds traumatic episodes in financial markets are preceded by periods of superficial calm.

Beneath the surface, investment managers compete increasingly frantically to find profitable strategies. Problems erupt when they all converge on the same strategy. Then the risk is of sudden price changes.

“The calmer the period, the more likely it unwinds as a crash,” he says.

With hurricanes, scientists’ predictive powers are far from perfect. Each season, however, they improve and populations develop ideas for intervening to reduce the ferocity of storms or at least their impact.

Should central banks or regulators embrace the science of complex systems in the same way as public authorities have harnessed models of weather systems? Maybe the idea that financial market crashes can be averted is far fetched.

But the good news, if Prof Johnson is correct, is the creation of “dragon kings” can be prevented. His modelling shows that intervention – something that changes investors’ minds – can work, although he warns that its effectiveness in inherently unstable situations can vary from moment to moment.

Janet Yellen, Fed chairwoman, this week argued against using interest rate changes to counter threats to financial stability – but her words alone carry weight and regulators have other tools. Step forward Ms Yellen the dragon slayer.