Forget the ‘New Normal’ — It’s All About the ‘New Volatility’
Strap in. The markets are about to get bumpy.
Hands up if you remember the last rate hike from the Federal Reserve? Keep your hand up if you remember what the interest rate was — and then take a gold star. Or, given your advanced years, maybe take an aspirin. If you remember that short-term rates hit 5.25 percent in June 2006, then unfortunately you’re no longer a young gun of the markets. But before you disappear into a pit of despair at your receding youth, be glad that you know more than two-thirds of Wall Street traders. With change happening at breakneck pace in financial markets, you’ll need that knowledge.
The market is about to face some big turning points with the coming Fed rate hike only one of the changes ahead. What’s different is that it will be doing so without the safety net of easy money that has been in place since late 2008. Central banks turned on the liquidity taps to avert economic disaster. Now that the world is recovering, those taps are turning off. As they do so, volatility will return to the market. It’s like a patient who has been close to death, heavily sedated through his recovery, and is now leaving the hospital: We might expect him to stumble as he readjusts to normal life. Particularly as the sedation won’t be forthcoming from the central banks now they’re stepping back.
The Fed has now made clear that a rate hike is coming this year. As Federal Reserve Bank of New York President Bill Dudley, considered a relatively centrist voice on the central bank’s monetary policy committee, said on June 5: “If the labor market continues to improve and inflation expectations remain well-anchored, then I would expect — in the absence of some dark cloud gathering over the growth outlook — to support a decision to begin normalizing monetary policy later this year.”
The employment picture is steadily improving, growth is solid (if not stellar), and inflation is starting to return. The excuses for the Fed to remain at what it sold as emergency levels of interest rates are starting to run out. True, there have been many false dawns in the past couple of years, with the economy appearing to reach escape velocity only to stutter at the last minute. And some economists, notably Larry Summers, have been describing the situation as “secular stagnation,” a term first coined by Alvin Hansen in the 1930s for a long-term slump in economic growth.
Yet while economists pick over the data, and politicians worry about what action to take, an earthquake is slowly taking place across all financial markets. Ever since the tumult of the global financial crisis, investors have become used to the idea that policymakers always step in to calm the markets when volatility spins out of control or credit crunches appear. When asset-backed securities went into free fall during the financial crisis, the authorities created a program that put a floor under the market. Where it dislocates, they provide a sling around the market’s bones to buy time while the crack heals. The alphabet soup of programs, from quantitative easing by the Bank of England and the Fed, to the Troubled Asset Relief Program by the U.S. government, and the Securities Market Program by the European Central Bank, and so on, were designed to soothe the market so that it could take price risks with fewer paroxysms of panic. Moral hazard — the knowledge that there would always be a safety net to catch any great fall — became the norm.
The trouble comes when you turn off the tap. The interventions have been so large, for so long, that they have created their own market distortions. The limitless liquidity is starting to look very reminiscent of the “savings glut” that then-Federal Reserve Chairman Ben Bernanke identified in a speech in 2005. This referred to a wall of ongoing liquidity from countries such as China, which invested with limitless enthusiasm in U.S. debt as they looked for a home for their surpluses. The glut ultimately provided a breeding ground for the risk-taking that culminated in the financial crisis.
With the massive government interventions, markets finally calmed down entering 2012. The average daily range in the euro-dollar exchange rate over a six-month period fell back to the lows of the decades previous to the crisis.
But then, last fall, it all changed.
On Oct. 15, 2014, the Treasury market underwent what is now termed a “flash crash” in yields. The yield on the benchmark 10-year note dropped from 2.02 percent to 1.86 percent in a matter of minutes, with the note’s price rising accordingly. Statisticians have since argued that this should only happen once in every 3 billion years.
This is no hyperbole. The U.S. Treasury market is one of the deepest and most liquid markets in the world, making such enormous moves extremely unlikely. Almost every size of financial institution, whether asset manager, hedge fund, or bank — all over the world — holds a stash of Treasurys, precisely because of their safety: Everyone knows what they are, how they’re priced, and where you can sell or buy them. With so many actors in the market, one would almost always be expected to buy notes and take profits when yields dropped so quickly. Sudden illiquid price moves in this asset just aren’t supposed to happen.
But it was only the opening salvo. On Jan. 15, the Swiss National Bank removed its currency floor for the Swiss franc. The currency appreciated by 30 percent in 20 minutes. Now, everyone expected there would be some pretty volatile moves if the floor were ever removed, simply because it would be happening at the point of most pressure. Yet almost no one in the foreign exchange markets expected a move of that magnitude. Foreign exchange is the most liquid market in the world, open 24 hours a day, almost six days of the week. Daily turnover is $5.3 trillion, according to the latest Bank for International Settlements survey. For a major currency pair to move that much, in that short a period of time, is unprecedented.
These events aren’t curiosities; they are a symptom of a much more fundamental shift in how we value our assets. If the least risky asset turns out to be incredibly risky, then what does that mean for the rest of your investments? If stable and boring Treasury bonds start being more volatile than a tech start-up stock, we should all be taking notice — it’s nothing less than a challenge to the markets’ very foundations.
Risky assets should give us higher returns, but we take more risk in the process. We see this throughout our lives — you might take a risk by leaving your job in search of a bigger paycheck, but it’s not as secure as just staying on the steady salary in your current job. Yet if the steady job might suddenly be under threat from layoffs, should you really stick with it? The same thing happens when the risk-return potential of a benchmark asset deviates from our expectations; it becomes difficult to construct a portfolio.
As it turns out, the central banks are aware that these events are more than curiosities and are a sign of something more significant. We have had warnings from all of the following: the Reserve Bank of Australia, the Bank of England, the International Monetary Fund, and the Bank for International Settlements. Yet it really only started to hit home with the stark warning in the European Central Bank meeting on June 2. ECB President Mario Draghi could not have been clearer when he said, “We should get used to periods of higher volatility.” The market was expecting him to deliver some more soothing comments. After all, the European bond markets had just gone through their own flash crash in prices, with German 10-year yields spiking up from 0.08 percent to 0.70 percent in the first two weeks of May. Draghi’s response to the markets was blunt: The ECB would keep its eye on things, but it had no immediate plans to intervene and ensure calm. This was a bombshell — the policymakers were stepping away, preferring for once to watch than to act.
Why? Draghi himself detailed a number of reasons at that ECB meeting. For one thing, higher interest rates are a sign of a return to economic growth. But the structure of markets has changed, too. New regulations mean that banks cannot play as active a role as market-makers, and high-frequency traders and their attendant technologies are creating unpredictable pockets of illiquidity that would arise so quickly and idiosyncratically that they might be very difficult to address.
How could the central banks and other financial institutions respond to new outbreaks of extreme volatility in the markets? Regulations such as the Volcker Rule in the United States, which effectively ruled out banks trading on their own books (known as “proprietary trading”), would need to be unwound so that banks could once again take risk on their own balance sheets — which would provide more bids and offers in the market, increasing liquidity. High-frequency trading would have to be more rigorously policed, but that wouldn’t be easy in a globalized world of free-flowing capital. Regulators could join together to clamp down on market-destabilizing behavior, providing they could agree on new policies before the terrain changed again. But there is a bigger question that would still remain: Should they even respond?
Central bankers are increasingly saying no. They tried to combat the volatility caused by the global financial crisis because it had a massive impact on the world economy. This time around, the volatility is considered a side effect of normal market mechanisms — the ebb and flow of buyers and sellers.
Volatility is the price of uncertainty — and we should be feeling more uncertain. Seven years of zero rates have passed, and the time is fast approaching for their removal. This is a brave new world. We just don’t know yet how the patient will find his rehabilitation after years of unprecedented sedation.
Young guns of the market may think they know about volatility, but they shouldn’t get too comfortable. We went through a stomach-churning roller coaster from the beginnings of the credit crunch until global trade was snuffed out by the fall of Lehman. Yet this is a different kind of volatility. It’s one we used to be more aware of when traders got through high-volume days by the skin of their teeth, way back before these new whippersnappers had ever heard of a Bloomberg terminal. Back then, when the science of behavioral finance was just a glint in an economist’s eye, volatility came out of the blue for reasons that no one could fully explain. Now, having passed through a period of greater predictability in the markets, that apparent randomness — which is really our inability to explain everything that’s happening — is back.
The onetime architects of the calmer markets aren’t doing anything to stop it. The endless provision of liquidity from central bankers is coming to an end. Markets are being left to their own devices, and a whole generation of traders has yet to realize it. We’re on our own now. The economics — stagnation or no — are becoming irrelevant to the markets. Hands up if you’re ready?
Photo credit: Carl Court/Getty Images
Correction, July 24, 2015: During the Oct. 15, 2014, “flash crash,” the 10-year Treasury yield fell from 2.02 percent at 9:33 a.m. ET to 1.86 percent at 9:39 a.m. ET, according to the official Joint Staff report on the event. A previous version of this article said that the yield dropped from 2.20 percent to 1.87 percent.