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NEW YORK (Reuters) - While U.S. stock market gyrations remain uncharacteristically subdued, derivatives analysts at some top Wall Street banks have started warning clients about the growing risk of increased market volatility.
Stocks remain near record highs and daily price fluctuations, by one measure, are close to being the most minimal in nearly half a century.
However, calm markets and buoyant stocks may be hiding the fact that the next volatility shock could be just around the corner, according to some analysts.
"Markets remain fragile," BofA Merrill Lynch Global Research analysts led by Benjamin Bowler said in a note on Tuesday.
The bank pins this on poor liquidity, low investor conviction and highly crowded positioning.
The sudden and sharp stocks slump in mid May, amid increased concerns about U.S. President Donald Trump's ability to deliver on tax cuts and other pro-business policies, while fleeting, shows the extent to which markets are prone to "flash crashes," the analysts said.
A rise in BofA Merrill Lynch's "fragility indicator," which measures the frequency and magnitude of abnormally large shocks for certain cross-asset volatilities and credit spreads, is also ringing alarm bells.
This indicator has been rising over the past six months even as cross-asset risk has fallen.
"While our base case remains a summer range-trade for the S&P 500 as policy and positioning 'collar' U.S. equities, identifying low-cost hedges for a 'fragility event' in U.S. equity volatility may be prudent," the BofA said.
JP Morgan analysts last week raised the possibility that stock trading could turn volatile, and fast.
The bank's analysts reiterated a call for market volatility to lift from record lows in the "near future."
With U.S. rates rising and monetary accommodation from the European Central Bank and the Bank of Japan expected to recede, there is likelihood of market turmoil in the medium term, JP Morgan said.
But just as these two banks are warning on volatility risks, investors have been pouring into exchange traded products (ETPs) linked to the CBOE Volatility Index .VIX, particularly the inverse VIX ETPs which are used to bet on prolonged calm.
Current positioning in these ETPs is near all-time extremes, according to BofA.
"A sudden shock to U.S. equities could pressure those invested in such strategies to short cover, thus exacerbating the rise in volatility," the bank says.
Reporting by Saqib Iqbal Ahmed; editing by Daniel Bases and Dan Grebler