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.
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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