There is a risk environment cycle which helps describe the view that we are moving from systemic to macroeconomic risks. We depict the environmental phases in Figure 1. This graph effectively describes the changing nature of asset market volatility over the last few years.
Phase I is the calm economic period where the market environment is well-known and volatility is low. This represents the longer-run environment over most of the last fifteen years before the current crisis. It has often been described as the macroeconomic period of “Great Moderation”. Although this period of calm was punctuated by the LTCM and tech bubble, it was generally a time of low market volatility especially during 2002-2007.
Phase II is the transition or shock period when new “news” enters the market. If there is no clear consensus on the impact of the shock, the diversity of opinions leads to higher market volatility. During the current crisis, this phase started with the housing decline in 2006 and 2007. The sub-prime market blow-up hit the economy as a shock which raised all asset volatilities because the impact on other markets was undefined and unexpected.
In Phase III, the market moves from volatility caused by dispersion of opinions to a higher volatility level based on true Knightian uncertainty, or an increase in unknown or immeasurable economic and policy risks. This phase is consistent with the post Lehman failure and AIG bail-out. The uncertainty concerning the rules of the game created a systemic risk environment with exceedingly high levels of volatility.
As true uncertainty is reduced, we enter Phase IV where the focus moves back to more defined and measurable risks because many of the unknowns become resolved. The market knows the central bank policy, the stimulus package, the immediate regulatory environment, etc…. The market again focuses on macroeconomic risks and the linkage with asset prices. As consensus grows concerning the impact of risks, there will be further calming of markets.
This cycle approach to volatility is consistent with the movement in the VIX index over the last nine months.[1] After rising to unprecedented levels, the VIX has declined as markets have become less anxious about the financial uncertainty of potential bank failures and the broad policy choices of the governments and central banks.[2]
Markets will continue to have a upward tilt if the level of uncertainty continues to decline.
[1] The risk attitudes of investors cannot be measured directly but revealed through the premiums in markets. Our risk aversion index which looks at volatility as well as a set of spreads across a number of different asset classes has moved from extreme risk avoidance to greater risk seeking.
[2] The cycle story also explains the stylized fact of volatility shocks followed by a slow decay as modeled with a GARCH process.
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