Recently, there has been a rising cacophony of voices warning about the low-volatility environment spawning complacency and excessive risk taking. In early June, Jon "Fedwire" Hilsenrath penned a WSJ article describing how various Fed officials had raised concerns about the low-volatility environment:
Federal Reserve officials are starting to wonder whether a tranquillity that has descended on financial markets is a sign that investors have become unafraid of the type of risk that could lead to bubbles and volatility.
One of the most prominent voices was Bill Dudley of the New York Fed, who is an Establishment figure in the Federal Reserve apparatus:
The Fed's growing worry-which could influence future interest rate decisions-is that if investors start taking undue risk it could lead to economic turbulence down the road.
"Volatility in the markets is unusually low," William Dudley, president of the Federal Reserve Bank of New York and a member of chairwoman Janet Yellen's inner circle, said after a speech last week. "I am a little bit nervous that people are taking too much comfort in this low-volatility period. As a consequence, they'll take more risk than really what's appropriate."
...and Fisher at the Dallas Fed:
Richard Fisher, president of the Federal Reserve Bank of Dallas, added to the chorus of concern over complacency in an interview Tuesday. "Low volatility I don't think is healthy," he said. "This indicates to me a little bit too much complacency that [interest] rates are going to stay at abnormally low levels forever."
For while ultra-low volatility might sound like good news in some respects (say, if you are a company trying to plan for the future), there is a stumbling block: as the economist Hyman Minksy observed, when conditions are calm, investors become complacent, assume too much leverage and create asset-price bubbles that eventually burst. Market tranquillity tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash.
That pattern played out back in 2007. There are good reasons to suspect it will recur, if this pattern continues, particularly given the scale of bubbles now emerging in some asset classes. Unless you believe that western central banks will be able to bend the markets to their will indefinitely. And that would be a dangerous bet indeed.
It also prompted John Mauldin to hit the panic button in a none too gentle fashion:
There is a bull market in complacency. As Dylan goes on to say, the illusion of central bank control is in full force. And one of the chief ironies is that a bull market can last longer than any of us can reasonably expect - and then end more abruptly than even the most cautious bulls suspect. The St. Louis Fed Financial Stress Index is at its lowest ebb since they began calculating the index. How much lower can it realistically go? The answer is that no one really knows.
I don't know what the trigger for the next debt crisis will be, but whatever it is, it will result in an even deeper liquidity crisis than we saw in '08. That is just the nature of the beast.
Mauldin went on to ask some critical questions (emphasis added):
You need to look into your portfolios, deep into your portfolios, and see what your various investments did back in 2008-09. Then take a deep, long, serious look in the mirror. Ask yourself, "Can I withstand another shock like that?" Do you think you are smart enough to pull the trigger to get out in time? Do you have automatic triggers that will cause you to exit without having to be emotionally involved? Are there illiquid assets in your portfolio that you want to own right on through the next crisis? (Let me note that there are a lot of assets about which you might answer positively, with a full-throated yes, in that regard.) Would you rather be biased to cash today, when cash is in a true bear market and at its lowest value in years, if that cash will give you the buying power to purchase assets at prices that will once again look like 2009's? Think about how you will feel in the wake of the next crisis, when cash will be king!
How risky is the environment?
My inner long-term investor is indeed concerned about signs of rising complacency and lower margin of safety (see This will end in tears, but when?). While recognizing that systemic risk is rising, the issue of timing the downturn is a non-trivial problem.
Ben Chabot of the Chicago Fed recently wrote an essay entitled "Is there a trade-off between low bond risk premiums and financial stability?" addressing this very issue. He concluded that just relying on low risk premium signals from the bond market to forecast potential spikes in volatility, i.e. Minsky Moments, generated too many "false positive" signals.
The hazard model results suggest that the current levels and past changes in risk premiums are poor predictors of the risk of future large increases in risk premiums. The level and change in the real fed funds rate and risk premiums are insignificant in most specifications. In the few cases where the variables do significantly shift the hazard, the sign is always the opposite of what one would expect if low risk premiums or accommodative monetary policy did indeed sow the seeds of future instability.
In fact, Chabot found a perverse effect that low risk premiums is likely to lead to more stability, not less:
The hazard model suggests large increases in risk premiums are less likely when risk premiums have been depressed or have declined over the past year.
It would therefore be wrong for policy makers to respond with more a aggressive monetary policy in order to try to prick potential financial bubbles precisely because low risk premiums, or complacency, have not always resulted in crashes (emphasis added):
Financial instability is costly. It has been suggested that low bond risk premiums may predict future financial instability and that policymakers should take this into account and respond to low risk premiums by adopting less accommodative monetary policy than would otherwise be justified by economic conditions. But before we conclude that the economic cost of a potentially sharp increase in bond risk premiums justifies less accommodative monetary policy, we should be certain that financial instability is in fact more likely to arise when bond risk premiums are low. This study casts doubt upon the hypothesis that low levels of bond risk premiums increase the likelihood of destabilizing sharp increases. To the contrary, the past 60 years of data suggest that large increases in bond risk premiums are independent of the recent level or change in risk premiums or the real federal funds rate.
Indeed, Goldman Sachs published a study of the history of volatility (via FT Alphaville) and showed that while the current vol environment is low, it is not at extreme levels.
As well, consider this chart from Tobias Levkovich of Citi (via FT Alphaville) of the relationship between the VIX and the next 12-month return of the SP 500. The R-Squared of the regression of the two variables turned out to be a minuscule 0.01:
It seems that the latest view from central bankers is to rely on macroprudent policies instead of monetary policy to guard against financial instability. Marc Chandler summarized the consensus view perfectly here (emphasis added):
We note that Draghi appeared to be singing from the same song book as Yellen regarding the use of monetary policy to address financial stability. Like the Fed Chair yesterday, Draghi indicated that macro-prudential measures and regulation is the first line of defense, not monetary policy (price and quantity of money). Monetary policy seems too blunt of an instrument and operates with unpredictable lags. Macro-prudential policy and regulatory efforts are more precise and can be implemented almost immediately. This is part of the new orthodoxy.
That view was confirmed by Janet Yellen's recent July 2, 2014 speech on the issue of Monetary Policy and Financial Stability (emphasis added):
In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. These efforts should be complemented by the use of countercyclical macroprudential tools, a few of which I will describe. But experience with such tools remains limited, and we have much to learn to use these measures effectively.
What about the pending Minsky Moment?
Even if we were to throw all of the regression analysis aside, ignore the Chicago Fed study and raise the alarm about how central bankers are encouraging excessive risk taking, how can investors avoid the instability of a Minsky Moment?
The answer is to look for possible triggers of instability. At the moment, there are few:
- The likelihood of a US recession is unlikely (via BCA Research). In fact, the weekly review of high frequency economic releases by New Deal Democrat came to the conclusion that "growth through the end of this year and into 2015 remains almost certain".
- Street consensus EPS growth continue to rise and are supportive of further market gains.
- Other triggers, such as geopolitical turmoil is unlikely to cause a major disruption to the markets (see "Ending in tears" doesn't mean that the market goes down right away).
My inner investor is enjoying these parties thrown by the Fed and ECB. He is getting a little uneasy and edging his way to the door, just in case the cops raid the place. On the other hand, my inner trader is staying with the bullish view and he is still dancing with the lampshade on his head. He refers the doomsters to the latest Josh Brown quote from Eric Peters (emphasis added):
"Should have known what to expect," he said, laughing at his own idiocy. "When you move into a house filled with 19yr old derelict degenerates, there's no going to sleep early." But refusing to cut and run, he traded out of the position. "I figured if these morons were going to keep me up till 2am listening to Pearl Jam, they were going have to pay." So he started a casino in the frat-house basement. That stank of stale beer and Skoal. But quickly overflowed with drunken gamblers, baseball caps turned backwards, drinking, dipping, crowded around blackjack tables. And indeed, they paid. Consistently. Reliably. He emerged from that basement stench to get his diploma. Tossed his cap. And headed to the ultimate casino. Wealthier. Wiser. "Built my entire business around buying carry, you'll never meet someone who loves it more than me," he said. I politely refused to take the other side. "So the fact that I can't bring myself to buy this stuff anymore is very bad news for other guys." But calling the end of a bull market is rather different from calling the beginning of a bear. The last great credit debacle in the US was the S+L crisis. Which was followed by an 8yr recovery. The 2008/09 crisis was far more severe and will be followed by a much longer, lackluster recovery. That's how economies recover from financial crises - and we're only 5 yrs into this one. "We're approaching an infection point, the past 5 yrs have been fantastic for financial assets, for carry, but not great for the real economy, and that relationship is now in the process of reversing." So he's jumping on this credit cycle's final trade. Buying every illiquid thing left, securitizing the crap, marking it up, creating new carry instruments. "To sell to some drunk idiots."
In other words, the end may be getting close, but it's not here yet. There is one more leg up. So don't worry, be happy!
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.