The Federal Reserve is concerned investors are too complacent and may be taking on too much risk, echoing recent comments from the European Central Bank and the Bank of England. The thing is, not only are central banks the perpetrators of the death of volatility, they are the knowing architects of the accompanying surge in asset prices.
Andrew Haldane, the chief economist at the Bank of England and one of the most eloquent policy makers around, described the environment in comments he made on quantitative easing at a Financial Times conference in London last week:
Lower rates and QE were an exercise in trying to stimulate risk taking. We're seeing risk change shape. That will mean, on average, that volatility in financial-market asset prices will be somewhat greater than in the past.
Haldane's argument is that the combined efforts of policy makers and regulators have driven risk-taking off from the balance sheets of the banking community; instead, it "shows up on the mark-to-market balance sheets of asset managers and other funds," he said. And, at some point, there's likely to be a whiplash as a consequence of the yield-chasing behavior of money in an era of zero or negative interest rates.
Here's what the Fed had to say yesterday, in the minutes of its June 17-18 Federal Open Market Committee meeting:
Measures of uncertainty in other financial markets also declined; results from the Desk’s primary dealer survey suggested this development might have reflected low realized volatilities, generally favorable economic news, less uncertainty for the path of monetary policy, and complacency on the part of market participants about potential risks.
Here's a chart illustrating the death of volatility:
It's an odd world indeed where the major central banks have all adopted the mantra of "lower for longer" on interest rates, and are now berating the financial community for listening. It's a bit like pushing someone into the lake and then telling them off for being wet. Nevertheless, there is a growing catalog of central bank warnings in recent weeks, including this from Bank of England Governor Mark Carney last month:
When we think about the medium term, we're very conscious that we've pushed liquidity risk into the private sector. Liquidity premia should be higher rather than lower. That's going to change at some point. I think it's a statement of the obvious, but you can couch that as a warning. We'll try to avoid saying `we told you so'."
Both Haldane and the Fed stressed that monetary policy isn't the tool they will be reaching for to curb any perceived market excesses. "Monetary policy can on occasions have a role to play in insuring against these financial stability risks, not as a first line of defense," Haldane said. The Fed accompanied its warning on complacency with "at the same time, it was noted that monetary policy needed to continue to promote the favorable financial conditions required to support the economic expansion."
So, to summarize: Central banks cut borrowing costs to zero and flooded the financial markets with liquidity, trashing volatility and yields everywhere: Investors responded by chasing risk in illiquid corners of the markets: And while everyone acknowledges that this movie might end badly, most of the global economy remains too weak for central banks to raise rates from abnormally low levels. Rearrange the words "back in the tube" and "putting the toothpaste" to describe the policy dilemma central bankers will be facing in the not-too distant future.
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