EXPLAINED: Here's What's Going On With Volatility In Global Markets Right Now
Volatility is on the increase in 2015 and the source of this uptick is central banks, guardians of the global financial system and previous dampeners of global market volatility.
This central bank induced volatility is the theme of an excellent piece of research from Deutsche Bank's Analyst Aleksandar Kocic, "Volatility - the finger and the stick."
Kocic likens the post GFC era, when central banks have thrown cash at the market and the economy in an effort to dampen downside volatility, to the act of balancing a stick on your finger.
Imagine you are asked to balance a long stick on your finger. By placing it vertically on your fingertip, the stick could fall either left or right from its initial position because standing upright is unstable. However, in trying to keep the stick vertical you instinctively (and randomly) wiggle your finger. The added randomness - "noise" - acts as a stabiliser of an otherwise unstable equilibrium.1 So long as the noise is administered carefully, the stick remains vertical, or "metastable". The withdrawal of noise becomes destabilising.
It's an apt analogy, you should try it.
The stick of course is the national and global economies and the finger is monetary policy and quantitative easing.
But you can't balance the stick forever - indeed you don't want to - just ask the SNB or the Fed.
The paradox of the current post crisis world Kocic says is that, "good economic news is now the most feared risk. No one wants any randomness to return, they prefer the stick to be still."
As a result, "central banks are caught," and the huge liquidity injections which moved risk from private to public balance sheets has dampened volatility to the point that:
Rock bottom interest rates and low volatility across the board was a high degree of correlation between different market sectors, with central bank flows and the distortions those introduced also contributing. Many markets became an extension of monetary policy. This in turn crowded out private investors, their participation now a function of liquidity injected.
The problem Kocic asserts is that, "risk does not disappear. It can only be transferred or postponed by temporarily suspending." The exit is key and "explains the tense dialogue between markets and central banks the moment the conditions show any sign of improvement."
Scarily while Kocic says the first part of the exit, the unwinding of correlations, started with the taper tantrum and taper talk in mid-2013 he says that, "return of volatility, is yet to really take off, not withstanding recent jitters around Russia and oil prices."
That's scary and traders are already getting a sense that 2015 is going to look very different to the last year or two in markets.
But central banks, like the Fed, are struggling to get markets back to normal function and Kocic says, "Mostly each attempt by the Fed to inject volatility back into the market has met with rejection. Goodness knows how central banks are going to move to act three and actually raise rates."
Dampening volatility was part of the global market recovery process in the wake of the GFC but returning it to the market is going to make 2015 a very interesting year.