Low volatility investors could benefit if the Fed opts to further tighten monetary policy and reduce its balance sheet.
By Nick Kalivas
As the nation's central bank, the Federal Reserve (the Fed) seeks to maximize employment, maintain price stability and keep long-term interest rates at moderate levels. To achieve these monetary goals, the Fed employs a variety of tools - the most common of which are "open market operations." Historically, the changing pace of these operations has had an effect on equity market volatility. I believe that exploring this relationship can provide insights to investors - especially those considering low volatility strategies.
What are open market operations?
The use of open market operations involves buying and selling US Treasury securities to affect the targeted fed funds rate and, by association, interest rates as a whole. When the Federal Open Market Committee sells Treasuries, it is indirectly reducing the money supply, as primary dealers draw on cash reserves to pay for these securities. Conversely, the Fed acquires Treasuries by funneling cash into the banking system, thereby increasing the amount of credit available to borrowers.
Large-scale asset purchases, known as "quantitative easing," have the effect of increasing the Fed's balance sheet. The latest round of quantitative easing following the 2008 financial crisis has resulted in more than $4.4 trillion on the Fed's balance sheet - the largest balance sheet expansion since World War II.1
The role of the Fed's balance sheet in sparking market volatility
Although the Fed has stipulated that expanding its balance sheet only be done as a temporary measure, investors have become accustomed to seeing ballooning assets on the Fed's ledgers. Because an expanding the Fed's balance sheet is viewed as evidence of monetary easing, reductions in that expansion have met with discomfort, owing to a weak growth environment, as well as heightened market volatility.
This phenomenon can be seen in the following graphic, which plots increases in equity market volatility, as measured by the CBOE Volatility Index (VIX), against the direction of the Fed's balance sheet, which is reflected in reserve bank credit. (Keep in mind that bank reserves and the Fed's balance sheet are positively correlated. As the Fed increases its own assets by purchasing Treasuries from banks, it is simultaneously increasing cash reserves.) Note in the blue dotted boxes that volatility has spiked in cases where reserve bank credit is flat to falling, while volatility has eased when bank reserves are rising. The red arrow depicts an uptick in volatility since January 2015.
Source: Bloomberg L.P., Feb. 1, 2016. Past performance is not a guarantee of future results.
Prior to the latest round of quantitative easing, there was about a two-year lag between changes in the fed funds rate and changes in equity volatility. More recently, the level of volatility has been driven more by the size of the Fed's balance sheet than by the overnight fed funds rate.
Reduced credit expansion as a catalyst to low volatility performance
Although the relationship is not perfect, the following graphic demonstrates that reduced expansion in the Fed's balance sheet has also coincided with the outperformance of low volatility investment strategies. Note the highlighted blue sections, where volatility (in the form of the ratio of the S&P 500 Low Volatility Index to the broader market S&P 500 Index) spiked during periods of flat to declining bank reserve balances (reduced expansion in Fed balance sheet).
Source: Bloomberg L.P., Feb. 1, 2016. Past performance is not a guarantee of future results.
As you can see, the periods of July 2011 to September 2011 and March 2012 to July 2012, which all saw declining bank reserves, provided support for equity volatility.
The relationship between Fed action and volatility may in part be linked to the lack of escape velocity (the ability to accelerate without fits and starts) in the economy and the perceptions of risk by the investment community. And while there's a general perception that easy monetary policy solves all problems, it's interesting to note that the recent budget deal was stimulative to the economy, with greater government spending and a large deficit. In theory, this should have improved the growth outlook and reduced risk. As is often the case, however, monetary policy seemed to trump fiscal policy.
There are still a number of obstacles to US economic growth, including reduced corporate earnings estimates, inventory overhang and uncertainty surrounding emerging market economies. But given the Fed's massive balance sheet and its decision last December to hike interest rates for the first time in nearly a decade, I consider it unlikely that near-term Fed policy will do anything to ease the risk of equity market volatility in the coming months.
Investors looking to gain exposure to low volatility investing may wish to consider the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV), which is based on the S&P 500 Low Volatility Index. Small cap and mid cap investors may wish to consider the PowerShares S&P SmallCap Low Volatility Portfolio (NYSEARCA:XSLV) and the PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA:XMLV).
- The Federal Reserve Bank of St. Louis, January 2014
Correlation is the degree to which two investments have historically moved in relation to each other.
The fed funds rate is the rate at which banks lend balances to each other overnight.
Volatility measures the standard deviation from a mean of historical prices of a security or portfolio
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was posted on the Invesco PowerShares' blog by Nick Kalivas on February 9, 2016: http://www.blog.invesco.us.com/fed-balance-sheet-and-equity-market-volatility-relationship