Can the low volatility bargain hold?
By James Saft
(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 ﬂavor 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.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(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 email@example.com and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)