Tuesday, January 8, 2013

No free lunch for central bankers

I got a fair amount of feedback from my post From anti-inflation to pro-inflation, where I described the journey that central bankers have taken from 1980 and the height of the Paul Volcker's tight monetary policy era. In the post-Lehman Crisis period, central bankers have changed their focus from fighting inflation to encouraging a little inflation, from monitoring money growth to loose monetary policy, quantitative easing, nominal GDP targeting and, finally, the loss of central bank independence coordination of monetary policy with fiscal authorities.

With the news that the new government is about to launch 12T Yen (USD 136 billion) fiscal stimulus program and the BoJ appearing to acquieces and support the stimulus with more bond buying, Japan is the country that has gone furthest down this road.

The market effects of the Bernanke and Draghi Put
I want to address in this post the likely effects of this shift in central bank thinking on market prices. In the wake of the near-death experience of the Lehman Crisis of 2008, central bankers have taken steps to put a floor on the price of financial assets. Market analysts have called this the Bernanke Put, as applied to the Federal Reserve, and the Draghi Put, as applied to the European Central Bank. These central bank Puts function like an insurance policy with a deductible. Investors assume some degree of risk, the deductible, but if the macro-economic situation deteriorates to the extent that a market crash is likely, major global central banks have they will step in to rescue the markets.

These insurance policies come with costs. To explain, standard financial theory posits that asset returns follow a bell-shaped distribution. The graph below shows an idealized Gaussian distribution with the returns plotted on the x-axis and frequency, or probability, of those returns on the y-axis. (Yes I know it's not normally distributed but has fatter tails, but it is still a bell-shaped curve.) But what happens to the return distribution when central bankers try to eliminate or reduce the left tail of the return distribution?

Trading Eurogeddon for lower growth
In Europe, where the ECB’s actions have been combined with a fiscal policy of “all austerity, all the time” and a social consensus that is tilted towards a relatively robust safety net, the ECB has traded off the certainty of a no Eurogeddon scenario against lower growth, as depicted by the idealized graph on the below. Note how the expected return distribution is no longer symmetrical as the left tail has been cut off. The “mode”, or the value that is likely to appear the most, is also skewed to the left.

The risk of a eurozone sovereign or banking crisis is off the table, but Europe is in recession. While the actions of the ECB has bought time for EU member states to move toward structural reform, the price paid is lower growth in the short-term.

Trading tail-risk for greater volatility
In addition, I believe that the actions of global central bankers have made the markets more volatile in the short-term. The FX team at Bank of America/Merrill Lynch (BoAML) (via FT Alphaville) observed that volatility in the euro-US Dollar exchange rate has risen dramatically in the past few years, as shown by the graph below.

The BoAML FX team observed that markets movements are now far more sensitive to policy decisions and headline news [emphasis added]:

It is perhaps somewhat counter-intuitive, as low volatility has traditionally been associated with low uncertainty, but we are still seeing high levels of uncertainty in FX. This is understandable given the large number of risks across multiple regions (for example, Eurozone financial crisis, weak US growth, US fiscal cliff and China slowdown). Further, these types of risks leave investors tracking policy makers and trading news headlines for policy trajectory information. This is resulting in sudden and rapid moves in FX followed by periods of range-trading.
By eliminating tail risk and raising certainty, central bankers have ironically raised short-term volatility instead.

In conclusion, central bankers can't completely eliminate volatility and their policies come with costs. In the case of Europe, the ECB has traded Eurogeddon for a recession. In general, market volatility has risen and become far more sensitive to headline news.

It just goes to show that there is no free lunch in central banking.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

keithpiccirillo said...

Creating a non random event can cause some chaos which leads to collective determinism, which creates our present condition: we are positively skewed,