Central banks have had a tremendous impact on financial markets in the last seven years, which is never more apparent than when looking at the world through the volatility lens. As shown in Chart 12, cross-asset volatility reached all-time lows in the summer of 2014, falling even below the 2007 pre-GFC bubble lows, crushed under the weight of unprecedented monetary policy (or in the ECB case, the promise of policy).
This is remarkable considering the size of the risk “bubble” created pre-GFC.
The result is that risk is not fairly priced based on fundamentals but rather is better explained by investors not wanting to stand in front of central banks as they embark on QE. As Chart 13 shows, when decomposing the 41 factors of risk covering 5 asset classes from our GFSI index into regions, both Europe and Japan (the two regions still actively engaging in QE) are the two regions with the most depressed price of risk. This is despite being the two developed regions with some of the greatest fundamental risk.
Unprecedented CB – market co-dependence
Central banks have never been more sensitive to financial market conditions as they are today. This hyper-sensitive reaction function has placed huge downward pressure on volatility, and has accentuated local shock behavior as investors have become accustomed to CBs verbally supporting the market at very low levels of stress compared to the past.
In the last three instances when our GFSI critical stress signal has triggered, during the taper tantrum in June 2013, the Oct 2014 growth tantrum, and the Aug 2015 China tantrum, central banks have stepped in to verbally support the market (Chart 14).
In each case central banks have reversed market stress, creating a string of three false signals, which is historically unusual. From 2000-2012, the GFSI’s critical stress signal triggered 15 times, 12 of which resulted in a further escalation of risk and a pull-back in global equities of at least 5%. This illustrates the extent to which central banks have essentially capped risk at levels where it historically was likely to spill over.
This has self-reinforced a “buy-the-dip” mentality which, together with the fact that investors have generally been underweight US equities this year, has caused the S&P to record larger returns on days the market was rising than when it was falling. Combined with the fact the S&P fell more days than it rose YTD but the market overall was up makes this historically unusual, occurring only 5 other years since 1928.
Pulling the safety net away will be risky
Arguably one of the reasons central banks have been so sensitive to market risk is that they are fearful of a negative wealth effect resulting from a financial market sell-off hurting the real-economy, given they have little monetary ammunition left. Keeping rates low to avoid the rising costs of record high debt burdens could also be a motive.
The US Fed’s fear was made particularly clear by Yellen’s decision to not hike in September, citing the sell-off in equities and China weakness, at a time when the S&P 500 was only about 10% below all-time highs.
However, the challenge will be to remove this safety net given how dependent the market has become. And once the Fed begins its hiking cycle, it may be implicitly less able to provide the support for fear of being seen as making a policy mistake. This reduced power of the CB put will only help increase market fragility.
Central bank’s risk manipulation well explains local tails
A good way to explain why we have seen local tail risks arise so frequently since central banks began to heavily manipulate asset prices is with the following analogy, illustrated in Exhibit 1.
Essentially central banks, by unfairly inflating asset prices have compressed risk like a spring to unfairly tight levels. Unfortunately, the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade. By manipulating markets they have also reduced investors’ inherent conviction by rendering fundamentals less relevant.
This then creates a highly unstable (fragile) situation that breaks violently when a sufficient catalyst causes risk to rise – overly crowded positioning meets a market with little conviction.
Catalysts can range from a “valuation scare” similar to Oct-14 or Aug-15 to a prominent investor stating that assets (e.g. bunds) are not fairly priced and are the “short of the century”.
The unwinds from these crowded positions are violent, but almost equally violent in some cases are the reversals, which are driven from investors crowding back in when they realize central banks are still there providing protection.
From this vantage point, it becomes clear that the biggest visible risk to financial markets is a loss of confidence in this omnipotent CB put.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
