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NY Fed Admits Higher Rates Mean Higher Volatility

In another well-funded research study, the New York Fed has, via its Liberty Street Economics blog, unveiled its explanation for why volatility is low (obviously missing the Kevin Henry-Citadel dark-pool VIX-slamming machinations that are so evident on an almost daily basis). Their findings are a little awkward for The Fed... the current volatility environment appears substantially different from what happened prior to the financial crisis. However, the Fed's conclusion, as Helen Thomas notes, is worrisome - low interest rates tend to mute volatility (something we already knew) - but if that is the case (from their findings) then implicitly: If low volatility is caused by low rates which in turn cause low volatility, what happens when rates go up?

 

As Liberty Street Economics blog notes,

Volatility, a measure of how much financial markets are fluctuating, has been near its record low in many asset classes. Over the last few decades, there have been only two other periods of similarly low volatility: in May 2013, and prior to the financial crisis in 2007. Is there anything we can learn from the recent period of low volatility versus what occurred slightly more than one year ago and seven years ago? Probably; the current volatility environment appears quite similar to the one in May 2013, but it’s substantially different from what happened prior to the financial crisis.

 

 

 

Broadly, our results confirm what has been reported in the press—namely that reduced uncertainty regarding the policy outlook, proxied by the dispersion of the three-month Treasury-bill forecast, as well as low levels of financial stress, are contributing to the recent low levels of volatility. Also, low interest rates tend to mute volatility, with the ten-year Treasury yield low by historical standards. These three variables were similarly low last May, contributing to the interpretation that current underlying fundamentals resemble those from a year ago. When thinking about what was happening back in 2007, there are some substantial differences. Uncertainty regarding short-term policy was higher, with survey forecast dispersion for the three-month Treasury bill being substantially greater than it was today or last year. Financial stress, as represented by the TED spread (the difference between the interest rates on interbank loans and Treasury bills), and the ten-year Treasury note yield were also higher. In contrast, households seemed much more certain in their outlook, based on the dispersion of forecasts from household surveys. This measure was substantially lower prior to the financial crisis, but is currently near average, as it was last May.

 

 

During times of relative market calm, like today, it could be that low financial market volatility is pushing these fundamental drivers lower, rather than the other way around. This note does not specifically address whether volatility is affecting or is being affected by these drivers.

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So, as Blonde Money blog adds,

Since the financial crisis, there has been a heightened awareness of how markets interact, and how a signal from one market can suggest that positions in another should be covered.

 

hen markets watch one another, this can cause volatility to propagate.

 

...

 

[The research above] says: Volatility is low because Treasury yields are low and not moving around very much. It’s very different to Lehman, when household confidence was in disarray, credit spreads were high and random news was flying around.

 

You may discount this as telling you what you already know. The authors themselves conclude:

 

"During times of relative market calm, like today, it could be that low financial market volatility is pushing these fundamental drivers lower, rather than the other way around."

 

But the ongoing conclusion from that is dynamite. If low volatility is caused by low rates which in turn cause low volatility, what happens when rates go up? Even worse, what are these alleged indicators of volatility telling us? Precisely nothing.

 

You can no longer place your portfolio in risky assets, sit back, and wait for an exogenous factor to tell you when to hedge. There are no exogenous factors. Volatility is eating itself, and when the market realises, we will be in for one hell of a panic.

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But then the Fed probably knows that...