Central bank policy has distorted many asset markets.
Financial markets have been remarkably tranquil of late. Traders accustomed to the ructions of recent years are now starved of volatility, with the US equity “fear index” (the Vix) continually falling towards pre-crisis lows (see graph, bottom left). As Gemma Godfrey of Brooks Macdonald points out, it’s not limited to stocks. Foreign exchange, commodities and fixed income are all experiencing levels of volatility far below the 10-year median (see graph, bottom right) – around 60 per cent lower in the case of Japanese government bonds.
For a growing number of analysts, this smacks of market complacency. “It’s very quiet out there – too quiet, just like in virtually every horror movie before someone gets violently dismembered,” says Michael Ingram of BGC Partners. The Bank for International Settlements recently warned that “euphoric” markets are disconnected from reality. And even Federal Reserve officials have raised concerns over “unusually low” levels of volatility, leading to fears of a possible Minsky Moment (named after economist Hyman Minsky), with market complacency leading to excessive risk-taking, and asset price bubbles that ultimately burst.
But not everyone is reading off the same script. The Vix closed last week at 10.32, eerily close to its pre-crisis levels in 2007. But Nick Beecroft of Saxo Capital Markets says that “there are reasons to think things are different this time.” First, some of the decline in volatility can be put down to rules restricting banks’ proprietary trading (speculating on price movements with their own money). If you agree with regulators that such behaviour can be destabilising (a contentious point), lower volatility could be welcome.
Moreover, less volatile equity markets could be seen as a reflection of more stable corporate earnings. Aneta Markowska of Societe Generale argued in a recent note that current levels are driven mainly by economic fundamentals, rather than liquidity-induced complacency. “While the Fed has probably contributed to the recent low levels of volatility in the market, we find that the low-risk environment is largely consistent with high profit margins and low leverage in the US corporate sector.” High profit margins in the US are a good proxy for reduced earnings volatility, she reasons, and the profit cycle isn’t showing any signs of running out of steam soon.
But it’s not just US equities that have experienced a sharp decline in volatility. Aside from Italy, most major bourses have seen levels well below their 10-year medians recently – around 25 per cent less for Germany, and almost 50 per cent less for the UK (see graph, right).
Combine this with the fact that most asset classes have seen similar drop-offs (Deutsche Bank’s FX Volatility Index closed at 5.24 per cent last Wednesday, the lowest closing level since August 2001), and it’s difficult to look beyond loose monetary policy from major central banks as the cause. As Godfrey has argued: “When it’s cheaper for Ireland to borrow than the United States, you have to be concerned about a disconnect between investor sentiment and economic reality.”
Richard McGuire of Rabobank says that the interventions of central banks mean markets have been “quasi-nationalised”, with price movements reflecting the messaging of central bankers as much as economic fundamentals. He points to the extremely low volatility on Japanese government bonds as an extreme case, reflecting the active stance of the Bank of Japan (BoJ) in recent years.
True, the Fed and the Bank of England are on a tightening course. But as the last year has shown, both are more than prepared to push back rate hike expectations if they feel markets are getting ahead of themselves. Further, the assets bought by the Fed through QE are now due to be held until maturity. And if the likes of Pimco’s Bill Gross are right, and supportive central bank policy is the “new normal” for developed economies, it’s hard to call an end to the current era of depressed volatility. “We’re all turning Japanese now,” McGuire says.
DANCING WITH CENTRAL BANKERS
This makes life difficult for traders. While it’s tempting to focus on geopolitical and macroeconomic shocks as sources of volatility, McGuire argues that the actions of central banks could act as a counterweight. A sharp growth slowdown in China, for example, would prompt a fall in commodity prices, exacerbating deflationary trends in Europe. “But the market would likely look through the fundamentals to the reaction of the European Central Bank, which would act to dampen volatility by increasing liquidity. It’s the triumph of the chequebook over the textbook.”
Central bankers and markets are locked in an ongoing dance with one another – it’s what volatility expert Christopher Cole of Artemis Capital has called the “postmodern economy”, with market expectations of central bank policy (itself partly influenced by markets) becoming just as important as the economic fundamentals of supply and demand.
The problem for traders and investors is that, with returns on cash so low, they have little option but to join in the dance.