Volatility: The Great Moderation, for now
Kathleen Stephansen Chief Economist AIG Global Economics May 19, 2014
This document is provided for informational purposes only and should not be relied on for decision-making prior to confirmation with independent sources. AIG is requesting confidential treatment of the information contained herein and the information is being submitted under 12 U.S.C. 1828(x). AIG further requests that it be notified pursuant to Federal Reserve Bank of New York (FRBNY) policy if the FRBNY is requested to disclose any information that AIG has shared with the FRBNY in its capacity as banking regulator and requests that it be afforded an opportunity to object to disclosure.
1
The importance of QE: Shaping Market Expectations Governor Jeremy C. Stein: “…QE3 has, in my view, mattered not just because of the direct downward pressure on longer-term interest rates associated with removing a given quantity of duration from the private market, but also because it has buttressed our forward guidance by serving as a credible signal of the Committee's intentions with respect to the future path of the federal funds rate.” Challenges for Monetary Policy Communication, At the Money Marketeers of New York University, New York, New York, May 6, 2014
That was not always the case: Volatility rose when the Fed stopped its purchases of mortgage-backed securities (MBS) in 2010. Buying structured products was buying risky assets, or volatility. The ensuing dearth of risky assets contributed to their rally. The timing of ending their purchases in 2010 was premature as the private sector was not ready to “step in” and provide necessary liquidity for the well-functioning of markets. With no support from the Fed, markets became vulnerable to shocks, e.g., the European sovereign crisis in 2012. Such market vulnerability forced central banks to re-think their exit strategies. The private sector demand for cash remained high, forcing central banks to continue providing liquidity. Swapping cash for riskier assets, or for consumption and investment spending, required central banks assist in the form of QE.
2
The importance of QE: The Fed as main provider of liquidity Credit market instruments (SAAR, Bil.$)
5000
MONETARY AUTHORITY
BANKS
GSEs+Mortgage Pools+ABS issuers
INSURANCE+PENSION
MUTUAL FUNDS
BROKER DEALERS & OTHER
4000
3000
2000
1000
0
-1000
-2000
-3000
Source: Federal Reserve, AGE
3
The rally in risk appetite: The VIX is close to pre-recession levels
VIX Index
90
QE1
QE2 Twist
QE3
80 70 60 50 40
34.70
30 19.69
19.37
20 10 0 2000
Tapering Tapering signaled announced
2002
Source: Bloomberg, AGE
2004
2006
2008
2010
2012
2014 4
QE lowered fixed income volatility
10yr UST Vol 260D
60
QE1
QE2 Twist
50
QE3 Tapering signaled
40 30
Tapering announced
20 10 0 2000
2002
Source: Bloomberg, AGE
2004
2006
2008
2010
2012
2014
5
Global central bank QE has lowered forex volatility Commitment from central banks to keep QE lowered FX volatility. (A recent exception is the Yen.) Commitment to keep interest rates near zero, even when tapering, has reduced the term risk and compressed interest rate differentials.
20
Trade Weighted Board USD Vol 260D QE1 QE2Twist QE3
20
18
18
16
16
14
14
12
12
10
JPY Spot
Euro Spot Tapering announced Tapering signaled
10
Tapering announced
8
Super Mario Speech
8
6 4 2000
JPY & Euro Spot Vol 260D QE1 QE2Twist QE3
Tapering signaled
2003
Source: Bloomberg, AGE
2006
2009
2012
6 4 2000
“Abeconomics� announced
2003
2006
2009
2012 6
US-EM Cross Correlation EM currency correlations diverged before the crisis and converged in recession. EM market converged again on Fed tapering talk: Mexico, Brazil, India, Indonesia, Turkey and South Africa tend to be the most constrained by Fed policy.
100% 80%
US-EM Cross Correlation (Major EM currencies) QE1
26-Week Avg
60%
QE2
Twist
54.20% 46.09%
40%
Super Mario Speech
25.97% 20%
Source: Bloomberg, AGE
Tapering announced
Tapering signaled
0% -20% 2000
QE3
2002
2004
2006
2008
2010
2012
2014 7
Preparing for the Exit: Will adjusting to firmer growth bring volatility? Governor Jeremy C. Stein: “… Market participants now appear to almost uniformly expect that, barring a material change in the outlook for the economy, the Committee is likely to continue tapering our purchases in further measured steps over the remainder of this year. With these expectations in place, the execution of the taper itself becomes much easier, as we no longer have to worry about a step-down at each meeting sending a potentially misleading message about our intentions with respect to the future path of the federal funds rate.” Three major themes are likely to dominate: Stronger demand from advanced economies, slower growth in China, and moderate capital outflows from EM triggered by QE tapering and eventually rate increases. Governor Stein ended his presentation with the assumption that if the Fed is known to react more aggressively to changes in economic conditions, the market would expect the Fed to behave in a less gradualist fashion, so any given move in the funds rate would have a smaller multiplier effect on long rates…. The jury is out on that view. We believe that financial markets are vulnerable to shifts in policy regime (as per the episode last summer) and will tend to be more volatile, as they readjust to firmer growth. Forward guidance remains an important, though maybe not sufficient, tool in mitigating the extent of re-pricing. 8
Regulatory environment: Less liquidity brings volatility New Basel capital standards and Dodd-Frank rules impact liquidity across fixed income asset classes. Institutions need to raise capital and reduce risk weighted assets. Credit Suisse reports that balance sheets of rates trading for the 10 largest US and European banks has fallen by almost 1/3 between 2010 and 2013 ($200 bn). (Interest Rate Strategy Focus, Ira Jersey, Credit Suisse, 05-08-2014.)
As the rates business shrink, revenues from credit and EM trading rise. But it begs the question as to whether smaller inventories and balance sheets in certain rate products may trigger larger price moves until a new equilibrium is reached.
9
Appendix: The QE Timeline 11/25/2008: QE1 announced 1/1/2009: QE1 started to purchase MBS 3/18/2009: QE1 increased the size to $750bn of MBS total up to $1.25 tr. Started to purchase up to $300bn UST 3/31/2010: QE1 ended 8/27/2010: QE2 signaled in Jackson Hole Speech 11/3/2010: QE2 announced to purchase $600bn UST until June 2011, starting from this month 6/30/2011: QE2 ended 9/21/2011: Operation Twist announced, buy long sell short (both $400bn) 6/20/2012: Operation Twist extended by $267bn until the end of 2012 9/13/2012: QE3 announced $40bn MBS per month 12/12/2012: So-called QE3.5 announced to buy $45bn UST in addition to $40bn MBS per month 5/22/2013: Tapering signaled 9/18/2013: No taper surprised the market 12/18/2013: Tapering started with $10bn reduction (split between MBS & UST) in each meeting
10
The statements provided herein are based solely on the opinions of AIG Global Economics and are being provided for general information purposes only. Neither the information nor any opinion expressed constitutes an offer or a solicitation to buy or sell any securities or other financial instruments. Any opinions provided herein should not be relied upon for investment decisions and may differ from those of other departments or divisions of American International Group, Inc. (“AIG”) or its affiliates. Certain information may be based on information received from sources AIG Global Economics considers reliable; however, the accuracy and completeness of such information cannot be guaranteed. Certain statements contained herein may constitute “projections,” “forecasts” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial information. Any opinions, projections, forecasts and forward-looking statements presented herein reflect the judgment of AIG Global Economics only as of the date of this document and are subject to change without notice. AIG has no obligation to provide updates or changes to these opinions, projections, forecasts and forward-looking statements. AIG is not soliciting or recommending any action based on any information in this document.
FOR INTERNAL USE ONLY
11