Opinion

James Saft

Can the low volatility bargain hold?: James Saft

June 3, 2014

June 3 (Reuters) – It is this year’s bargain: central banks
will remain easy, allowing asset prices to march higher despite
all those pesky details about growth and inflation.

There is lots of evidence to show this is a genuine
phenomenon – the ECB is expected to ease on Thursday, perhaps in
new and creative ways, and the Federal Reserve, while theorizing
about some fine day it will raise rates, is careful not to
encourage any breath-holding.

And markets are doing their part, with asset prices of both
stocks and bonds rising slowly and steadily, all amidst
unusually low volatility. Not only is the benchmark S&P 500
index up 5 percent this year, and 17 percent over one
full year, yields on benchmark 10-year U.S. government bonds
have fallen strongly in most major markets, powering
gains almost across the board in fixed income.

Low volatility may be key to understanding both what is
happening and why. Investors apparently aren’t afraid of
unexpected moves – using an index of volatility on the S&P 500
as a gauge, the Vix, they are as calm as they have been
since before the financial crisis.

The positive read on that is that investors are calm for
good reason. While the economy is not taking off, companies are
profitable, swimming in cash and actively buying up their own
shares and increasing dividends. That inflation and wage growth
are both too low, this thinking goes, is bad news more for those
who sell labor than those who own assets. Central banks want to
drive up inflation to safer territory, and to help labor markets
heal. Part of the price they are paying to fix that is to stoke
asset prices. If rising asset prices are no longer the central
plank of their strategy, as arguably they were in earlier stages
of quantitative easing, now it is a side-effect, one unlikely to
go away.

“You may disagree with the message (as I do), but if central
banks are either correct or strongly committed to using low
and stable rates as the ticket to stronger growth, investors
will respond by ramping up risk,” Citibank foreign exchange
strategist Steven Englander wrote in a note to clients.

Englander argues that central banks may end up being so
successful in convincing the market that rates will stay low for
a long time that they will be forced to manufacture volatility
in order to stop asset market overheating.

DESTROYED OR SUPPRESSED?

That view, logical as it is, may prove to be giving central
banks too much credit, both for their ability to plan and their
ability to control.

On another view the volatility now lacking in markets hasn’t
been destroyed, or somehow turned into higher asset prices, it
has simply been suppressed.

That is more or less what happened a decade ago, when
markets calmly marched upwards, using more and more leverage as
they went until finally exploding in a massive outbreak of
destructive volatility.

That is also, essentially, what happened in the economy.
Economists, for a time, were fond of expounding on the idea of
the ‘great moderation’, a sort of permanent period of calm
brought on by enlightened macroeconomic management. It wasn’t a
moderation, it was a suppression, and most suppressions
ultimately lead to violent reactions.

David Levy, of economic forecasters Levy & Co, buys into the
idea of low rates to the extent that he is giving a 75 percent
probability to there being no increases in official U.S. rates
through the end of 2019, a zero-interest decade, as it were.

Levy is far more skeptical about the faith put in central
banks. “Most commentators, both at home and abroad, appear
oblivious to critical economic developments while overly
interested in monetary policies with dwindling relevance,” he
writes in his most recent letter to clients.

“There persists a surfeit of public discourse about when the
Fed will taper bond purchases, when it will begin raising the
federal funds rate, what avor of unconventional monetary policy
the European Central Bank will serve up, and what new tricks the
People’s Bank of China may have up its sleeve.”

Instead perhaps we ought to focus not on the men behind the
curtain, but on the fact that the euro zone hasn’t got to grips
with its banking problems, that China’s growth has been fueled
by doubtful debts and that much of the private paying down of
debt in the U.S. now seems to have reversed.

None of this is to advise fighting the central banks and
betting on a spike in volatility.

That would be foolish, though maybe slightly less foolish
than depending on central banks, smooth sailing and gently
rising asset prices.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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