The volatility cycle and asset markets

What has been surprising for 2009 has been the strong decline in the volatility as measured by the VIX. Now we may all have agreed that a VIX level above 50% or even 30% wold have been too high, but the VIX is now down to 20% which lowest level since August of 2008. If the trend continue and we do not have any spikes we will be pre-2007 crisis levels. market volatility as measured by the VIX has moved through some distinct periods (thanks to VIX and More blog for cycle analysis):

1990-94 - Decline the savings and loan recession period
1994-96 - Flat - The period of calm with stable US growth
1996-98 - Rising - The Asian crisis and LTCM crisis period
1999-02 - Flat - period of rising tech bubble
2002-07 - Decline - period of cheap money
2007-09 - Increasing - period of crisis
2009 - - Decline - period of post crisis calm

These periods were not without spikes but there was a general direction for volatility. Given the number of problems that may be faced by governments, it is not clear that 2010 will be another year of declining volatility. We expect that the market will be in a period of flat vol around the 20-25% range. We will not go back to the calm of 2004-2007.

Dollar - stock correlation changing

One of the key stories of 2009 was the the risk-on / risk-off trade which closely tied currency movements with changes in the S&P 500. The switch between risk-on and risk-off was probable the single greatest risk for trading currencies in 2009. The stock market DXY index showed some of the highest sustained negative correlations in the decade. The relationship between stock prices and currencies has never been very stable, but 2009 as notable for the strength of the relationship and its relative stability throughout the year. We are starting to see a change in the last month and this may be one of the key trading relationships for 2010.

What was the risk-on trade? Every time the stock market started to move positive, there was a dollar decline as investors believed that a recovery was in hand. Investors moved from the dollar safe haven to other parts of the globe. A stock market decline would pull the global money back into the dollar. Some of these flows were associated with investors wanting to hold higher beta risk. Some was also associated with the belief that emerging markets were gong to do better than the US. This was realized. The total return for the US lagged the rest of the world especially for emerging markets.

SPY - 27.64% YTD
EFA - 28.37% YTD
EEM - 67.63% YTD

In December the picture changed with the stock gains associated with dollar increases. The switch has now been that rising stocks suggest stronger economy which has caused money flows to increase the value of the dollar. So what is difference between these periods? It is hard to say other than the first part of the year was still a reversal of the flight to quality flows from the fourth quarter of 2008. The market is now focused on the US economy as a place for investments and not as a place for safety at this time. Of course, this story is a description not based on actual numbers for the month.

We will have to look at the change in TIC flows to see the change in behavior. The latest Treasury numbers are from October (released on December 18th) and they show a slowdown in the purchase of US securities by foreigners. Stock purchases were down about $5 billion for the month. The net purchase of foreign asset by US investors was down with US investors being net sellers. This is a trend that has picked up. We have clear evidence that US investors have changed direction in the last few months. This is significant and may be the driver we are looking for. The US investor has gone from a net buyer of foreign stocks to a net seller to the tune of almost $20 billion. This change in US investor flow may be worth watching.

The doom loop - are we in one?

Question during the Bernanke confirmation hearings.

Q: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?

A. The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. A. (continued) In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.

Simon Johnson has written on this issue and has been pushing for an answer from the Fed. He argues that the time inconsistency issue is key to the problem. We say we will not bail-out and then we go ahead and do it. The further bail-out of Fannie and Freddie which was announced this week is a perfect example. We will talk tough and then cave-in and everyone in the financial world knows it.

I would argue that the doom loop is more an issue of monetary policy than regulation. If you do not let rates fall to such low levels, there will not be the speculative behavior seen by financial institutions. There is not a need for special regulation and monitoring if there is not loose monetary policy. The time inconsistency policy is also an issue of Fed credibility and whether investors believe there is a Bernanke (formerly Greenspan) put in the market. Whether there is the Fed credibility should be the focus of the confirmation hearings. Put differently, what should the Fed be creditable about?

Speculators don't drive oil prices?

JP Morgan released a provocative study that analyzed oil price movements over the last few years and found that over 90% of the variation was caused by inventory or supply changes. These supply and demand shocks dominated any activity by speculators. Of course, this begs the question of whether the people who have inventory speculate on prices. In fact, the CFTC released trader information which showed that the net positions of financial firms was actually decreasing during the run-up in prices during 2008. It is possible that smart money actually did not believe that prices would reach such high levels.

Most important, this study suggests that the market for oil is more complex than what we believe. Rising prices does no imply that speculators are causing the run-up. You could answer that there is no complexity when price responds to supply and demand shocks, but the difficulties arise from the sensitivity of price to changes in fundamentals. Given the strong need for oil across so many businesses, any change in inventory may translate into a price move that is more exaggerated. The action is in the elasticities of demand and supply which are much different than other markets. The tightness n oil markets can lead to strong price responses when there is an inventory shortage.

Now there will be some that argue that having JP Morgan conclude that speculators do not drive the market is like having the fox guard the hen house, but the burden is now on the CFTC to show what is the the transmission mechanism between speculation and price movement. I look forward to seeing that study.