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Why Central Banks Need More Volatility (To Maintain Their Omnipotence)
Will volatility become a policy tool? The PBOC decided that enough was enough with the ever-strengthening Yuan and are trying to gently break the back of the world's largest carry trade by increasing uncertainty about the currency. As Citi's Stephen Englander notes, this somewhat odd dilemma (of increasing uncertainty to maintain stability) is exactly what the rest of the world's planners need to do - Central banks will need more FX and asset market volatility in order to provide low rates for an extended period... here's why.
Via Citi's Stephen Englander,
Will central banks need volatility to restrain asset prices?
- Cyclical and trend growth pessimism is leading central banks to guide expectations of rates downward
- The more credible the guidance, the more risk will be bought
- To prevent asset market overheating while keeping rates low, central bankers may have to introduce more volatility into asset markets...
- ...emphasizing risk and vigilance and central bank readiness to raise rates if needed
Central banks will need more FX and asset market volatility in order to provide low rates for an extended period. The argument goes like this:
1) Low realized and implied volatility have come as a surprise to investors
2) Investors are underinvested out of skepticism that the low rates, low volatility environment will persist
3) If the central bank mantra of “low rates, low vol forever” persists in asset markets, investors will buy high beta assets and add leverage
4) Asset prices will respond much more to rates incentives than (so-called) rates sensitive sectors of the economy
5) Central banks want to keep the low rates without creating an asset bubble and will purposely induce volatility to calm speculation
The big surprise this year is the reduction in FX and asset market volatility (Figures 1, 2) Realized USDBRL volatility over the last month is where EURUSD vol was in Q1 2013. Since it was unexpected, investors were underinvested and even wrongly positioned as volatility declined.
Investors were not convinced on low yields for well into the year. On April 28, US 5-year yields were 1.74%, much closer to the 1.80% year high than to today’s 1.52%. Two year yields were within 2bps of 2014 highs. Conversations with investors suggest that they are still underinvested in risk because they are afraid that a) the low rates, low vol environment will not persist and b) they are petrified that liquidity will disappear in EM and G10 carry trades if a negative shock hits. The image of picking up nickels in front of a steamroller is often invoked.
Fear is fading as carry trades have looked better and better. The correspondence between currency returns and higher yield has improved dramatically (Figure 3). Over the last month, the top five currencies appreciated 1.8% on average and had a carry return of 0.62%, the weakest currencies fell an average of 1.7% and had a carry return of zero. Put the other way, the highest yielders had a carry return of 0.8% and an FX return of 1.2%, the lowest yielders had a zero carry return and fell 0.7% on average.
High yield will go some way to convincing investors that carry is the way to avoid underperformance. We have already seen some turnaround in return indices, but most remain negative YTD (Figure 4). The sharp run-up in the HFR macro index suggests that leveraged investors may have recently shifted positions dramatically.
A very slow moving steam roller - Central banks are seducing investors into carry trades. The choice of words may be more elliptical but if G4 central bankers are committed to the view that policy rates and growth rates will be far below historical norms and converge to these new norms slowly, they are hardly screaming fire in the carry trade cinema. If there is a steam roller threatening the nickel grabbers, it is by implication a very slow moving one.
Many investors still have the asset market blow up of 2008-09 on the radar screen, but the decline of volatility combined with central bank guidance makes it hard to resist the high beta siren song. The 1.6% pickup in the HFR index of macro returns in the last couple of weeks suggests that some investors are getting the message. 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.
The definition of insanity
A catchy section title and I do not think central bankers are insane. The combo of low rates and QE seems to have helped asset markets a great deal (Figure 5). GDP continues to disappoint, so it is hard to argue that the upside surprise has been on the activity side. So the question is why lower terminal rate expectations and slower rate normalization should have a bigger impact on activity relative to asset markets than over the past five years. We expect that if investors buy into the central bank view of where and how fast rates will move, we will continue to see gains in asset prices that will look at odds with the underlying pessimism on growth that is driving the policy message.
Will vol become a policy tool?
Central banks are guiding investors on the terminal points on policy and long-term rates and the speed at which they get there. They may be left with volatility around that path as the way by which asset market froth is discouraged. If they fear overheating but need the low rates for growth, generating uncertainty around that path will be a potential way of discouraging undesired leverage and yield grabs. We are assuming that higher volatility will discourage yield grabs in asset markets more than it discourages activity. We suspect this is the case, but do not yet see a clear way to proving it empirically.
Figure 6 shows the 52-week correlation of AUD and non-AUD G10 FX volatility (see note to Figure 6). We do not want to use AUD volatility because vol is likely to be higher if AUD is falling. Using non-AUD volatility means that we are safe from the criticism that AUD spot moves are causing AUD vol moves as much as vol moves are causing AUD spot to move. In a multiple regression framework we find that a 1-unit rise in non-AUD G10 volatility has about the same impact as a 20bps shift in 2-yr rate differentials, so higher volatility can discourage carry trades. This is very likely true for other yield trades as well.
Hence, it may be the way forward for central banks to mitigate the asset market implications of successful forward guidance.
* * *
And with the world and his dog short volatility (as the following chart of VIX futures shows)...
It is clear that while the CNY carry trade was China's problem (and funded the world), financial fragility (or stability) in Western asset markets is dependent on the "sell Volatility" carry trade... and maybe it's time for the central banks to break the back of that massive one-way bet...
That might be a problem... given the last time the market was this net short volatility, VIX explode higher...
Source: Citi and Bloomberg
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They're about to get a lot moar than they can handle perhaps!
The CBs have caused what's known as "pilot induced oscillation" in the aviation world.
And it doesn't end well at all!
Completely agree. The main problem is that none of this guys ever studied control theory as applied to non linear dynamic systems. If they had they wouldn't show the arrogance they do. Nor would they dare to put at the risk they are putting their masters.
Easy. CBs are in bed with their governments and those governments can't take rising interest rates because they are already in too much debt. Rising interest rates will definitely bankrupt them.
But then too endless money printing makes it worthless and so how does a government pay for its military to stay in power?
This is one of the prime factors why China and Russia are flexing their military might against the West.
It's also why they have been stacking gold while the Western banksters are desperately trying to manipulate gold lower to undermine Eurasia's financial and thus military advantage of having so much gold.
Citi is full of bullshit and this guy appears to be right up there at the top of the list. The truth is the big banks make a lot more money when markets are volatile and being traded heavily than when they are dead in the water like they are right now. Look for a false flag to tank equities (thereby increasing volatility and bank profits), and stimulate a rush into bonds (lowering interest rates to prolong the FedGov game as long as possible).
http://www.ft.com/cms/s/0/6a954088-e5cb-11e3-aeef-00144feabdc0.html#axzz...
I agree, however IMO the CBs have leveraged the financial system to the hilt for decades to the point where it's now highly unstable and perhaps uncontrollable. (see PIO above)
Profits are one thing. Survivability is quite another.
I agree that they will probably create (yet another) false flag to drive volatility. However, they have engineered a market that is now oblivious to external news. Hell they had a flood in the DTCC vaults, then when the water was pumped out a mysterious fire devoured all of the PM swaps contracts obscuring actual PM ownership. The rigged market shrugged. Maybe their HFT bots can manipulate the vol contracts for them.
Up arrow. Gov't needs zirp to survive and CB's volatility to intervene. They know what they're doing.
We expect that if investors buy into the central bank view of where and how fast rates will move, we will continue to see gains in asset prices that will look at odds with the underlying pessimism on growth that is driving the policy message.
We also expect that if investors no longer buy into the central bank view of where and how fast rates will move, we will continue to see gains in asset prices that look at odds with the underlying pessisism on growth that is driving the policy message.
zirp bitches.
VIX spike will create a huge BTD.
What are they waiting for?
...it was barzini all along
different subject, but I think it's important
Syria's Looming Water Calamityhttp://www.danielpipes.org/blog/2014/06/syria-looming-water-calamity
There is 9 Meals from Anarchy
and how many cups of water from anarchy ?
Soooooo are we saying it is time to rigg & manipulate the markets a different way than how they have been rigging & manipulating them?
Just to keep folks off balance?
Of course, this is an old story.
Ordo ab chao! Where is the doubt?
The high frequency, micro level churn is captured by HFTs.
The slow moving, macro churn is good old regulatory capture (at the highest levels, borders, fines, sanctions, price setting, taxes, duties...all control levers).
Both ends covered tightly. One by the club of rome. The other by the club of more ;-)
Machine, machine, machine machine machine...if anyone re-members Kraftwork, those German prophets....
http://aadivaahan.wordpress.com/2010/06/28/the-age-of-machines/
if they want it, they'll get it! (till it all blows up)
Nice Job Mr.Englander
Not even sheep are this stupid.
the skim is too high, boys.
If you want more bets, you gotta stop raking the pot for every g-dam card .....
Perfect analogy!
I don't get it. If Central Banks are impotent why don't they just get their MD to write a prescription
for Viagra like everyone else?
this is truly masterful. governments debase their currency to gain a competative edge. so, I guess businesses are failing because that is the new way to succeed.
if all this backwards logic is true then the world economy has never been better.
"Why Central Banks Need More Volatility (To Maintain Their Omnipotence)"
The central banksters need more cover for their unraveling ponzi.
"The guillotines are waiting."
I assume rioting and mob violence are good for the economy too.