Wednesday, June 4, 2014

Change Your Thoughts on Low Volatility!

I have lost count of the number of articles read recently about the decidedly low level of volatility.  The general comment is that people just do not appreciate the risk inherent in the markets today and like 2007, we are due a very nasty surprise.  I have another, possibly enlightening, take on the current low level of volatility.  First, I would note that last year, I had been keen on watching after a bullish VIX development in candlestick analysis that suggested important support near a multi-year low.  I further suggested the once this support level  at 11.52 was broken with the VIX showing consecutive settlements below, a longer-run (1-2 years) of period of generally low volatility in equities along with grinding and modest gains would be forthcoming.  That ‘bullish window’ was closed and the low volatility, slow grinding equity improvement is expected.  

However, because of the strong sentiment currently surrounding widely expected bearish prospect for equities as a result of low volatility, I believe the risk NOW is actually to an opposite extreme.  There is a risk that equities could move dramatically higher as few have positioned for an immediate move higher.  

As to the reason for volatility being lower today and why this is not like 2007:
Central Banks like it or not have tremendous sway on markets.  Their sway is greater when they have a captive audience that believes they have that sway and will continue to offer ‘visibility’ over a longer period.  I want to make a very strong distinction between ‘visibility’ and ‘transparency’, the latter having received an inordinate amount of attention in monetary policy circles over the last decade or so.  The general premise for monetary policy ‘transparency’ is that it allows economic agents to make better decisions and provides a feedback-loop for policy makers.

‘Visibility’ I like to say is the value (for economic agents) in that ‘transparency’.  When the Fed is transparent and that transparency leads to a greater awareness of what is forthcoming, that transparency has provided ‘visibility’.  Transparency does not always provide visibility.  You will remember how transparent the Fed was in late 2007 through late 2008.  At that time the Fed unfortunately was as confused as anyone and was unable to provide true ‘guidance’ as to how they would react with monetary policy and what the implications of those policies changes would be to financial markets and economic development. 

Today, the Fed is giving tremendous ‘visibility’ thorough transparency on the tapering of securities purchases, the likely holding period of SOMA, the likely ‘lift-off’ date for policy rates and the likely path of rates (steepness of ascent) following lift-off.  All of this transparency lends itself to greater visibility.  It was especially so for what I have called the ‘policy-path’ tapering of securities purchases as this stair-step reduction in purchases was articulated rather succinctly upon initial announcement in the December ‘13 FOMC statement.  The known path of policy for tapering allowed economic agents to easily map out discrete incremental changes in purchases and ready for these changes.  This then provided support.  An unknown when it was blurted out in mid-‘13 by Bernanke at the June ’13 FOMC had become a known ‘policy-path’, providing ‘visibility’ and true guidance. 

All of the above known’s are a reason for low volatility.  They are engineered by the Fed and other Central Banks and we clearly expect to be advised along the way when policy intent changes.  The Fed has pushed us into buying riskier assets and we have to some degree agreed to be pushed.  The Fed will tell us when it is less advantageous to hold risky assets, but at the same time they will provide a path for policy rates that will offer the visibility needed to support to economic growth.  In the run-up to 2007 that many now want to liken today’s low volatility to, the Fed had provided too much guidance.  They advised us they were going to reduce accommodation at a ‘measured pace’ and did so seventeen times.  No better monetary policy roadmap was ever afforded economic agents and by their own designs, these agents decided that the successive hurdle rates shown by the Feds policy path would be their guide to determining what internal rate of return was available in the leverage they accumulated through mal-investment.   

The point being, the Fed did not ‘push’ economic agents into risky trades back in ’05-’06, people figured out what the Fed’s policy path was and took advantage of leverage, knowing what the cost of funds would be over the next 6-9 months.  The economy at the time was strong and Fed officials were trying instead to determine how important the glut of global savings was and if financial innovation an issue.  Instead, the issue was the Fed was providing extraordinary ‘visibility’ in a period of supposed ‘restrictive monetary policy initiative’.  What happened was that the visibility went away quickly when the Fed transitioned from restrictive to ‘Oh-No’. 

Today, financial leverage is not the problem.  The problem is animal spirits, or lack there-of. The economy is growing and will grow stronger.  The Fed is accommodative and will remain so for a long time.  Low volatility and reduced trading volumes today may mean that there is not the edge there once was for Wall Street to profit from quick analysis of new knowledge.  Instead, low volatility and the generally grinding bullish equity trade I envision over the coming years is likely to benefit Main Street as much as Wall Street…and that is not terribly bad.    By; Martin McGuire

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