Why Volatility Simply Cannot Rise

The Heisenberg


Summary


• Transparency, generally seen as a defining feature of post-crisis policy, has a dark side.

• It blinds investors to long-term risks by removing the incentive to consider them.

• Caught in the information exchange loop, markets become numb.


“ For the past decade, traders have been conditioned to expect central banks to both telegraph policy tweaks ahead of time and offer a thorough rationalization of those shifts at the time of implementation.

Canada’s central bank provided neither when hiking its benchmark rate to 1 percent on Sept. 6. Monetary policy makers hadn’t spoken publicly since July 12, when they delivered their first increase in almost seven years, nor was the latest decision followed by a press conference.

That's from Bloomberg's Luke Kawa and the suggestion is that Stephen Poloz is attempting to change the prevailing dynamic.

Years ago, central banks instituted a running dialogue with markets, in the process creating a deeply reflexive relationship. There was always a tacit acknowledgement from policymakers that their reaction functions included a careful consideration of how risk assets like stocks (SPY) have recently behaved. But this is no longer tacit. It is all but explicit.

The idea behind forward guidance or, more colloquially, "transparency" is to ensure that markets are prepared for potentially meaningful policy shifts. It's assumed that telegraphing these shifts is critical in the post-crisis world because this is an environment where markets have become accustomed to excessive and persistent accommodation. Aware of the conditioning, central banks (rightly) assume that the removal of accommodation could be destabilizing. Thus, it's necessary to be as transparent as possible even to the point of "telegraphing the telegraphing." That is, policymakers are not only keen on warning markets about policy shifts, they are now predisposed to warning markets about when those warnings are coming. That's an endless regression.

More than a few commentators have suggested that this isn't desirable - that incessant central bank jawboning is creating perverse incentives. Rarely does a week pass when we don't hear from an influential central banker in the form of a speech, a media appearance, etc. In many cases, the Fed, the ECB, and other developed market central banks find themselves having to talk back things they just said. One official makes a speech, the market "misreads" it, and another official has to be trotted out the next day to explain why traders misinterpreted things. Again, this happens almost every single week.

Deutsche Bank’s Aleksandar Kocic has variously described this in the theatre context - it is, as Kocic famously wrote in 2015, "the removal of the fourth wall." You have ceased to be a passive spectator in the central bank drama. You are not merely an observer of a play unfolding on the policy stage. You are, to quote Kocic, “an alterable observer who is able to alter.” That is, you are helping to write the script.

By including you in the play, the Fed is effectively long an option to act on your behalf. That option was financed by selling an out-of-the-money option on policymaker credibility.

The problem with this regime is that it renders everything outside of the communication channel between you (markets) and the Fed irrelevant. As Kocic writes in a new note out Friday evening, "without a rigid reference point, like well a specified reaction function, objectives, and triggers, policy risks deteriorating into a matter of referendum." Here's how I described it early Saturday morning:

“This is just a kind of rolling plebiscite. Clearly, that creates substantial risks in terms of encouraging mass myopia. Thanks to near-daily speeches and media appearances by Fed officials, this is quite literally a real-time information exchange between markets and policymakers. No one can see outside of this information exchange and if you’re a trader, there’s really no utility in trying.

Note the bit about "mass myopia." If no one can see outside of the daily information exchange between the Fed and markets, then no one can form any kind of long-term view. Here's Kocic again:

“ In the environment of abundant information, everything becomes short term. A long-term vision becomes progressively more difficult to construct and things that take more time to mature receive less and less attention.

The communication loop between the Fed and the markets has become a way of controlling the residual risks associated with their exit. Excessive transparency has been perceived as the most effective way to stabilize the system. When used in this context, it confirms and optimizes only what already exists. The markets remain blind to what lies outside of the context of informational exchange.


In this situation, volatility simply cannot sustain a spike. And I mean that less as a subjective assessment and more as an objective statement. Unless the Fed decides or is forced (both of those are unlikely) to stop being transparent, volatility (VXX) cannot sustain a bid.

It's worth noting, given all of this, that in the week through Tuesday, the net spec VIX short hit another new record:


 (Bloomberg)


Those interested can read more from Kocic on all of this here, but for our purposes, just note that the dynamic outlined above has the perverse effect of amplifying whatever risks lie outside of the market-central bank information exchange channel by eliminating the incentive for investors to consider them.

The risks are out there, but why would you look?