At certain points in recent years I’ve had the feeling that the cure is remarkably similar to what killed in the first place. Lending at rates that fail to reflect risks to nations already encumbered with debt, which is part of the reason why they ended up overly indebted. Add to this government intervention in the housing market (in the UK), which was (among other things) one of causes of the financial crisis (sub-prime in America). Now we are in a position whereby central bank policies, which have included a strong emphasis on forward guidance and not rocking the boat, have contributed to multi-year lows in volatility, which is now something central bankers appear increasingly concerned about.
In equities this can be seen in the VIX, which is close to the post-crisis low of March last year and in the bottom 2% of the range seen since 2008. In FX, DB’s CVIX index hit multi-year lows at the start of May, levels last seen in mid-2007, which is when some (myself included) date the start of the global financial crisis. It was not the Lehman’s moment, but it’s when the early sub-prime fund defaults started and banks stopped lending to each other. Measures of bond market volatility tell a similar story. All these rely on a range of option volatilities and simply put (there’s an option-related pun there!), option pricing relies on volatility of the underlying asset. Low implied volatility says that the market is putting a low price on future expected price changes.
At some point, central bankers of the world will realise they cannot have it both ways, in other words implement policies designed to reassure markets (together with households and businesses) and at the same time, express concern that markets are too complacent of the risks ahead. The outgoing BoE Governor Charlie Bean suggested this in comments yesterday, stating that the exit path of “exceptionally stimulatory monetary stance” won’t be easy and that market interest rates are bound to become more volatile as a result.
There needs to be a change in approach. In March, Fed Chair Yellen caused fractures in markets when she suggested that it would be around 6 months after tapering ends that rates will rise. That’s the wrong sort of guidance, for the mere fact that neither she nor anyone else can predict the future to that degree. What is needed is less guidance, to allow markets to price risks more appropriately and not place such reliance on the assurance of central banks. Forward guidance worked in the early part of the financial crisis, but its time has passed (especially for the Fed and BoE) and as much as it may feel wrong, central bankers have to play their part in this re-adjustment.
Simon Smith