Rangebound volatility - will this last?

There has been limited volatility as measure by the VIX index and the ranges show it. There has not been a sustained month of high volatility above 20% since the second quarter of 2012. The monthly ranges have increased, but have generally stayed below the 20% threshold. The last big taste of high volatility was during the post-QE2 period which was one of the contributing reasons for Operation Twist. It could argued that the normalization of unconventional monetary policies allowed for lower equity volatility. The greater current policy uncertainty toward long-run monetary normalization has increased the volatility of volatility over the last four months.

The market question is whether as rates rise will there be a sustained increased in the VIX. It does not seem that credit will be constrained with incremental increases in the Fed funds, but this may be a key risk facing the market starting at the end of the second quarter. 

Liquidity - the macro prudential issue that counts

"Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there." -Howard Marks 

What is the liquidity premium that you will pay to have an asset that holds its price when you want to sell it? How much do you need to be compensated for an asset that cannot be sold immediately? These are question that are not often asked by investors make an initial purchase, yet pricing this trade-off between return and liquidity is critical in any financial downturn.

How much liquidity will I need during "bad times"? Again, this contingency is not often planned for by investors, yet in bad times there will be a greater need for liquid assets since income may be impaired. 

Do I prefer a less volatile investment in an illiquid asset or a more volatile investment in a liquid asset? Liquid assets which are priced by the market are generally more volatile than assets that are priced by dealers or through a model. How much extra return do I need for this volatility?

Can everyone have liquidity at the same time? Since liquidity is based on both buyers and sellers in the market, there has to be two way flow and differences of opinion or there is no liquidity. Everyone cannot have good at the same time.

Understanding liquidity is no different than understanding where the exits are in a crowded theatre. The time and cost of getting out of the theatre are a lot different in an emergency than when times are calm. Thinking of liquidity does not require extreme behavior like holding high cash levels, but it does require strategic as well as tactical planning. Bad times are a predictable surprise. Unexpected negative events will occur and investors should not be surprised when there is a liquidity shortfall. 

Liquidity is like the price of water - cheap  in good times but priceless when there is a shortage.

Ben Bernanke's blog - important reading

The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.

The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.

-Ben Bernanke's new blog

Those quotes are from the first posting of Ben Bernanke's new blog for the Brookings Institute. It is quite interesting to have the former Fed Chairman say that the Fed cannot affect interest rates. Of course, the comments are true in the long-run, but the Fed has always been trying to push rates above or below the neutral or equilibrium rate to hit its long-term targets. This is the measure of tight or loose monetary policy.

This is discussion on the level of the neutral rate and how rates are determined is the critical issue of 2015. If the neutral rate of interest has fallen and is closer to zero, then the Fed will and should keep rates lower for a longer period of time. Raising rates will create a tightening bias. Normalization under a low neutral rate will not require significant rate hikes. If the neutral rate is closer to the long-term trend in growth or 2%, then rates will  have to move much higher for normalization. 

If the neutral rate is closer to zero, then bonds are really not overvalued. Investors should be less worried about a bond bubble. The right determination of the neutral rates is what every investor should be thinking about at this time.

Yellen speech - learning something new or more of the same?

I reviewed the Yellen speech given at the San Francisco Fed last week. The comments are most recent views of the Chairman and it was focused on an audience of professional economists. There is a lot of content on the surface with a good review of many key issues in monetary economics, but in the end the content was empty if you were looking for "forward guidance" on rate directions. Patience is still the watchword even if it is not used by the FOMC. There is a significant amount of misguidance on what markets should expect. Yellen is not telling us anything wrong. The Chairman is just not providing insight on how action will be taken except that it will be flexible with conditions at any given time. If the purpose of forward guidance is to provide clear concise information on policy. You did not get it. 

I can agree with the summary seen in a number of economic blogs. 

• Rates will rise some time this year, but maybe not immediately. The SEP forecasts, Fed funds, and forecasters have said this for some time. Nothing new here. 
• The rate adjustment will be gradual. We already expect that this could take years and the Fed has no clear idea of how to get rates normalized quickly. 
• Policy lags are significant. We do not know what those lengths are in the unconventional world of zero rates. This tells us the no one know what the reaction will be to current or future policy.
• Inflation is going to be a guide for these adjustments. If there is no inflation, there will be no rise in the Fed funds. 
• Everything is going to be flexible. The wording is data dependent but the real policy is just discretion. 

All this means is that following Fed speeches is a loser's game. Follow the markets through price trends and fundamentals. Have a cocktail with friends and chat about Fed policy but leave the heavy lifting of investment decisions to a clear set of decision rules. The Yellen speech was like a Seinfeld episode - a lot of little stories but ultimately a show about nothing.