Is it complacency, or simply trader paralysis?
A question we first asked three months ago is getting a second wind this morning, when in a report by Deutsche Bank's Alan Ruskin - "Vol: freeze or flight?" - the macro strategist points out that "the new 2017 Nobel laureate for Economics is not the only one at a loss to explain low stock market volatility, and thinks investors are in ‘freeze mode’ in the midst of global uncertainties."
According to Ruskin, however, it's all about to change.
But why? And what is "the most likely causes of a shift to ‘flight mode’ and a rise in volatility? Here’s one possibility: by the end of next year, the combined expansion of all the major Central Bank balance sheets will have collapsed from a 12 month growth rate of $2 trillion per annum to zero."
But before we get to the inevitable next step, here's Deutsche Bank on how we got to the current state of paralytic complacency, or whatever one wants to call it.
To be sure, the wire headlines were catchy: “Nobel prize winner Thaler admits to not understanding the low volatility in the stock market.” The behavioural economist went on to note that investors appeared to be in “freeze” rather than “flight mode”. There are, according to Ruskin, at least three broad explanations for the current low volatility world, and why investor “freeze” appears to be favoured over “flight”, including:
- On the behavioural economics side there is the suggestion that many equity investors have entered at good levels and are capable of withstanding fairly sizable negative shocks; and, investors can’t trade or at least time, hypothetical apocalyptic events like a N.Korea accident;
- On the real economy side – the global recovery may be slow but it is remarkably steady. In the last five years, the IMF’s world growth estimate has varied between a low of 3.02% in 2012 and a high of 3.17% in 2016! The global growth rate is itself just about frozen. Similarly, inflation is not just a story of trend disinflation, but of inflation inertia, evident in inflation neither rising as much as expected in the recovery; or, less remarked, falling as much in the Great Recession
- And then there is policy. Central Banks have contributed to low volatility through at least three avenues: a) at its most extreme the BOJ have literally frozen JGB yields, while other Central Banks have been intent on keeping bond yields low; b) the ‘stock effect’ of QE, means that there is strong legacy influence of past unorthodox easing which stabilises the bond market even as Central Banks shift to tighten; c) the post 2008 asymmetric policy approach, to ease when risk is vulnerable, but not remove emergency accommodation on asset market ebullience, represented the globalisation of ‘the Greenspan put’.
Indeed' as shown previously, it's not just equities.
Of the above factors, the forces that have contributed to subdued bond market volatility are likely to be drivers of low volatility in all other asset classes, most obviously equities. Meanwhile, currencies have tended to show slightly greater vol than bonds or equities would suggest, which is probably because they are the best vehicle to express some idiosyncratic political stories, not least related to the rise of populism/nationalism.
Still, with the VIX once again knocking on eight's door, Ruskin believes that vol is "near its lower limit" and lists the following four reasons why:
- Can the real growth and inflation trends remain any more compliant? After all US and global measures are both in the perfect “not too hot not too cold zone”. We may have already past the point where inflation is at its most vol depressant, and US inflation is seen being more supportive of vol in H2 next year;
- Central banks, if anything, are likely to be wary of lower vol, that was seen as a potential catalyst for excessive risk taking before the 2008 crisis. Similarly Central Banks will avail themselves of the lower volatility that is associated with strong risky asset performance and easier financial conditions by continuing the process of policy normalization that will support vol. Yes normalization will be done at a “gradual” pace that precludes persistent disruptive spikes in vol, but only as long inflation remains reasonably quiescent.
- We only have only limited experience with the ‘stock versus flow’ effects of QE. 2018 will see the world’s most important Central Bank balance sheets shift from a 12 month expansion of more than $2 trillion, to a broadly flat position by the end of 2018, assuming the Fed and ECB act according to expectations. The QT that was feared surrounding the taper-tantrum never happened in 2014/15, but will very likely occur in 2018/19.
- Will the Fed’s balance sheet exit work as smoothly as the econometric work equating the Fed’s 2018 balance sheet reduction to a 15bpincrease in the 10y yield? Coefficients tend to change over time, not least if there are other forces pushing in the same direction, leading to a compounding effect. Higher inflation and/or other Central Bank QE tapering from the likes of the ECB could compound the expected small negative bond influence from the Fed balance sheet adjustment.
To be sure, we have heard it all before, most recently in June, when Citi's Matt King showed the exact same chart of collapsing central bank flow, and warned that a "significant unbalancing is coming"
For those who missed it, here are some of King's notable comments:
Next year looks very different. We project that the private sector will have to absorb c.$1tn of securities – the highest number since 2012. The main driver for this is our anticipated reduction in ECB purchases from €780bn this year to €150bn in 2018. The faster pace of Fed balance sheet reduction we can now expect cements our impression that next year will see a big shift away from the current status quo. Assuming that Fed balance sheet reduction begins in September, the US market will have to absorb a further $450bn of supply in addition to the gap left by the ECB
The Citi strategist was not optimistic on risk assets once the balance sheet unwind begins, noting that "given how tight spreads are to fundamentals and, even more importantly, the ultimate trajectory of central bank support, we remain confident that the next major move for credit will be towards wider spreads."
King then concluded by looking at the upcoming collapse in central bank security injections that "the likelihood that in markets a significant un-balancing (or perhaps that should be re-balancing?) is coming."
Ruskin's conclusion is identical:
"As we look at what could shake the panoply of low vol forces, it is the thaw in Central Bank policy as they retreat from emergency measures that is potentially most intriguing/worrying. We are likely to be nearing a low point for major market bond and equity vol, and if the catalyst is policy it will likely come from positive volatility QE ‘flow effect’ being more powerful than the vol depressant ‘stock effect’. To twist a phrase from another well know Chicago economist: Vol may not always and everywhere be a monetary phenomena – but this is the first place to look for economic catalysts over the coming year."
Assuming that Ruskin - and King - are correct, the consequences for risk assets, once the market grasps the implications, will be dire, however the outcome is far from certain: after all we have been at this pre-taper junction before, and every time the market threatened even a modest correction some Fed talking head comes out and hints at QEx and easier financial conditions.
Will this time be any different? The answer, according to the market for the time being at least, is a resounding no.