Combining volatility (fear indexes) - a strong indicator

 

We know that many investors use the VIX index as a fear gauge or just a measure of market risk. We also know that the same investors use the MOVE index to measure volatility and fear in the bond market. Some researchers decided to look at the divergence between these two indices as perhaps a stronger signal; see "Divergence of Fear Gauges and Stock Market Returns". The authors find that the divergence of fear indexes (regressing MOVE on VIX and using the residuals and the MOVE/VIX ratio) is a negative predictor of future equity market returns. This predictor does well for both in-sample and out-of-sample tests. 

Looking at the difference between MOVE and VIX indexes is a simple measure that can be followed by almost any investor. Simplcity may make this indicator obsolete if "everyone" is using it, but in the near term, we think this is a good, simple signal tool that I have been using for some time in different forms.

What does gold arbitrage tell us about globaliization

 

Gold quality is the same worldwide. There are differences in purity which can be accounted for in price, but an oz of gold in Shanghai, London, or New York should fetch the same price within a range. The price range difference should reflect the cost of transporting physical gold from one location to another. The tightness of price differences around the world is a measure of the fissure of globalization and free trade. If the world is in a free trade environment, gold price differences should be within the range of transport costs. If there are large differences in locational prices, trade is disrupted. 

A close look at price differences across major gold markets suggests an arbitrage breakdown due to tariff uncertainty in 2025. There has also been a disconnect in physical markets due to the desire of major buyers to hold gold in their own domiciles. As gold has become in short supply in some locations, there has been a disconnect that cannot be solved by the usual form of transportation arbitrage. This is a sign of a bubble, but also a sign that investors and physical users do not want to have geographical uncertainty.

Fiscal versus moentary dominance - the real battle

Janet Yellen, who served as both Treasury Secretary and Fed chairman, presented "The Future of the Fed: Central Bank Independence and Fiscal Dominance" at the AEA convention earlier this month. She does a thoughtful job of describing the differences between these two forms of dominance, yet she misses the mark in her description of the current environment.

We cannot continue independence and monetary dominance if there is a fiscal crisis. Fiscal policy saw periods of deficit and then a return to something normal; however, in the last decade, or since the Great Financial Crisis, there has been a change in government debt dynamics, so that fiscal policy has a more dominant role in monetary policy. Dominant does not mean controlling. In this example, fiscal dominance means the issues with fiscal policy have a more dramatic impact on the economy than monetary policy.

The current debt levels cannot be sustained with a growing amount of tax revenue used to pay interest on debt. The Fed has ignored this fiscal crisis. They have refused to comment on rising debt-to-GDP ratios to avoid being political. Yet the ongoing QE process, coupled with Fed high Treasury balances, shows that the Fed has lost its monetary dominance and must deal with a debt crisis. 

Trump's desire to lower interest rates is just an extreme manifestation of the fiscal dominance needed to sustain current government policy. Let's not forget that inflation is one way of getting out of a fiscal bind. If there were controlled deficits, there would not be a need to discuss lower interest rates. The fiscal excesses of the past have to be addressed. Yet, who wants to say we have a debt problem?  

Once again, our foecasting skill is poor

We try and try, but the results are always the same. We are not good forecasters. Should we stop trying to predict? That would be the obvious answer, yet anyone who invests needs to make assumptions, which are forecasts. The easy answer is to diversify, but there are assumptions about what may happen in the future. The classic 60/40 stock/bond mix will not last forever. 

Turn the loser's game into one where you can limit downside. Provide ranges and not point forecasts. The key is knowing your limitations when it comes to forecasting. If you are likely to be wrong, think in terms of probabilities. Think about the impact of being wrong and how much exposure you would like to have.