The most notable thing in the financial markets today is the absence of anything notable: volatility has collapsed to near-historic lows. Take a look at the accompanying chart from Bianco Research. It shows that Vix, a measure of how volatile stocks are expected to be based on options prices, has dropped to its lowest since 2007. Bond volatility is creeping closer to the historic lows reached a year ago, just before the taper tantrum. And foreign exchange volatility is also back to the lows of 2007.
Volatility in equity, bond and FX markets, via Bianco Research
Before we discuss the implications, let's examine why asset prices are so stable. A decade ago economists proclaimed that, since 1982, the rich world, and America in particular, had entered the "Great Moderation": an era of infrequent, shallow recessions, low and stable inflation, and limited quarter-to-quarter volatility. That talk came to an end with the crisis and recession. But as our article in this week's issue shows, the Great Moderation seems to be back. Judged by quarter-to-quarter swings in GDP growth and month-to-month variation in job growth, the economy has been as stable since 2009 as it was in the years before the crisis, which were the least volatile of the post-war era.
Since the macroeconomy is the primary driver of asset prices, a low-vol economy, all else equal, produces low-vol markets. But there's more going on. Before 2007, economists attributed much of the great moderation to judicious monetary policy: central banks had been quicker to ease in the face of economic weakness, and quicker to tighten to head off incipient inflation. The resulting swings in interest rates would have raised market volatility, offsetting some of the impact of stable economic output. So, for example, when the Fed started tightening in 1987 to head off inflation, the stock market crashed. But then the Fed eased, so the crash did not derail the economy.
This formula doesn't work for the post-2008 period because the zero lower bound has constrained the ability of major central banks to ease in the face of too-high unemployment. They have found alternatives, though: quantitative easing and forward guidance. These have had the practical effect of squeezing any uncertainty about interest rates out of the market at least for the next year. Check out the latest Fed survey of primary dealers and you will see 100% agreement (or, at any rate, complete agreement by the middle 50% of resopndents). This sort of agreement is made possible only by the zero lower bound and explicit guidance. Certainty about monetary policy has stripped volatility out of bond yields which in turn has drained a major source of uncertainty out of stock prices. At root, volatility simply represents uncertainty about the value of an asset's cash flows, so when volatility falls, the risk premium required to hold the asset also falls, driving price-earnings ratios for stocks up and bond yields down.
Is this a good thing? If lower volatility results from a structural change in the economy - and the stability of inflation surely qualifies - then there's nothing to worry about. It is simply an appropriate repricing of risk. It's more complicated, though, if it is the result of a particular stance of monetary policy. Easier monetary policy works by driving up asset prices, which generates spending both via a wealth effect, stimulates investment by lowering the hurdle rate for new projects, and shifts spending from the future into the present. If, in the process, it causes volatility to fall and asset prices to rise to artificial levels, that is a price worth paying; presumably, when the need for such stimulative policy ends, assets will reprice, and this will facilitate the tightening of monetary policy. Dennis DeBusschere of ISI Group sent around a chart today showing that the level of Vix contains no information about the future direction of prices. Yes, high vol follows low vol, but that tells us little about what happens to asset prices during the transition.
But there are deeper reasons to fret. One reason folks on Wall Street are deeply skeptical, if not downright hostile, to the Fed's policies is that they believe volatility is the natural order of things and artificially suppressing it via monetary policy is morally equivalent to price fixing, and more practically, bound to end in tears when the system's natural instability returns. I don't have much sympathy with the moral arguments; all monetary regimes fix the price of something in terms of money: bonds, short-term treasury bills, foreign exchange, gold. But I do worry that by squeezing out short-term volatility, we may be storing up long-term volatility. Hyman Minsky had spent most of the post-war years developing his thesis that stability begets instability, and died, in 1996, before he saw it vindicated with the "Minsky moment" of 2008.
I recently had an interesting exchange with Lewis Alexander. He's now chief U.S. economist for Nomura but spent much of the 1980s and 1990s at the Fed, before going to Citigroup and finally, during the crisis, to Treasury. He recalls:
In the spring of 2007 I was asked to give a presentation on the great moderation to Myron Scholes’ hedge fund. I talked about the key themes ... – inventories, consumer credit, and the stabilizing role of policy. Just five minutes into my presentation Myron cut in and asked “But won’t people just take on more risk?” That was the most prescient question I heard before the crisis.
I have come to believe that the ultimate cause of the financial crisis in 2007-2009 was the great moderation. The financial system responds to volatility. When volatility declines the natural tendency is to use more leverage and to concentrate risk. That was the essence of Myron’s question.
It is natural, in some sense, that the broad response of the financial system to the decline in macroeconomic volatility would play out in mortgage finance because mortgage finance is the biggest part of the system. Of course policy mistakes in housing finance played a role and with better policies we probably could have avoided the particular problems that arose in that sector.
I’ve come to believe, however, that had we gotten everything right in housing finance the tendency of the financial system to take on more leverage and to concentrate risk in response to lower macroeconomic volatility would have played out in some other part of the system. The crisis would no doubt have been different, and possibly less severe and later. But I think it would have come. That’s what comes from studying financial history.
Everyone is familiar with the signs of excess and reach for yield now: surging volumes of leveraged loan and junk bond issues, the renewed popularity of carry trades, the fact Greece can issue bonds at 5%. Mr Alexander adds a few others: high frequency trading and exchange traded funds:
Under adverse scenarios liquidity can collapse, and, as with ETFs, the assumption that long-term securities can be easily (and instantly) traded in liquid markets can act sort of like maturity transformation. The non-linear dynamics inherent in these markets can generate a collapse in liquidity and “fire-sale” dynamics in asset prices. I have a hard time coming up with a scenario for a systemic crisis that starts with HFT, but it’s not hard to see it acting as a propagating mechanism.
This doesn't mean a systemic crisis is on the horizon; the post-2008 financial reforms have forced the core of the financial system to significantly delever and reduce its reliance on short-term whole sale funding which is vulnerable to runs. But it's easy to imagine eruptions of lesser levels of distress. Moreover, the prolonged period of low-interest rates will provoke more and more financial innovation - as Minsky would have predicted - to get around regulatory limits on leverage.
This means the Great Moderation is different from what we thought a decade ago. It may reduce the periodicity of the business cycle, but increase the amplitude. Two charts by Jason Furman, chairman of the Counci of Economic Advisers, neatly illustrate this. The first is the variance of annual growth around its long-run average; the second is the variance of the 10-year average of growth around its long-run average. At shorter horizons, volatility has declined; at longer horizons, it has risen - a lot.
Even if a systemic crisis on the scale of 2008 remains a long way off, there are plenty of reasons to fret that the next disruption could be quite damaging. One is that it would begin with interest rates at or near zero, giving the Fed very little of its traditional power to soften the blow. This is why it is dangerous, as Larry Summers notes, to rely exclusively on monetary policy to boost growth. But the alternative - of tightening monetary policy - hardly seems a solution, since, given the current low level of inflation and ample slack, it would simply hasten the onset of recession and send interest rates back to the zero bound. Another alternative would be to use regulation to reduce the buildup of leverage. But that would also reduce the efficicacy of monetary policy which, after all, works by encouraging borrowing. Absent some politically acceptable fiscal stimulus or a supply-side productivity boom, the world may be be stuck with low volatility, nervously waiting for the day it suddenly, and violently, changes.
