By Tim Taschler, CMT
For the past two months, the focus has been on the Fed’s 180-degree reversal from being on autopilot, with regard to raising rates and shrinking their balance sheet, to going on hold. A big driver of the change, in my opinion, was the December beatdown in stocks driven by problems in the credit market. Now, however, there is another problem: the Interest On Excess Reserves (IOER) dropped below the Federal Funds Rate (FFR), something that should not occur.
CONCERN OVER LIQUIDITY
FFR went above IOER on March 20, 2019, and has pretty much stayed there. At their last meeting, the Fed made, what it called, a “technical adjustment” by cutting the IOER in an attempt to bring it under the FFR. It didn’t work. Now it appears that both the Fed and the Trump Administration have concerns about USD liquidity. It will be interesting to watch how this plays out.
Up until this pause, the Fed had been raising rates, albeit in tiny increments, since December 2015. As history has shown, rate hike cycles usually continue until something breaks and the economy rolls into a recession. It’s too early to say if the economy is recession bound, but in all likelihood, the Fed is done raising rates.
NEGATIVE INTEREST RATES CONTINUE
An interesting record was recently eclipsed — negative-yielding debt has surpassed $10.5 trillion globally:
Why is there such demand for bonds that you pay to own (as opposed to collecting interest)? It could be due to low inflation rates. Here in the U.S. we are seeing lower and lower peaks in the core inflation rate:
GLOBAL GROWTH DECLINES
According to a May 24 report from the National Bank of Canada, “the global economy saw its first back-to-back quarterly decline in trade volumes since the 2008-09 recession.” The report further states that “declining trade is wreaking havoc in export-centric economies such as emerging markets where exports fell for a second consecutive quarter. So much so that, as today’s Hot Charts show, the ratio of industrial production to export volumes, a proxy for inventories, jumped in the first quarter of 2019 to the highest since 2002Q1. Such inventory build does not bode well for production and hence world GDP growth over the rest of the year.”
BMO shows just how severe the drop in global trade has become:
Where will all this lead? Probably more growth in the Fed’s balance sheet, as this Bloomberg article highlights.
Stock market volatility has risen while traders (especially the so-called “algos”) make moves based on headlines from Fed speakers and the trade wars. More specifically, as ridiculous as this is, tweets by Trump matter.
A lot of people I interact with think that volatility is mean reverting. That is to say that any sharp rise or fall in volatility, as measured by the VIX for example, would be followed by a reversion back to the average value.
A recent MarketWatch article provides a clear example.
Published May 17, 2019, 2:20 p.m. ET:
“The Cboe Volatility Index VIX, +2.29% touched an intraday high at 23.38 on May 9, representing a more than 80% surge from its comparatively recent intraday nadir of 12.80 put in on May 3, according to FactSet data.
“However, the gauge, which maintains a historical average of between 19 and 20, is currently hanging around 15.50, as of Thursday trade.
“The JPMorgan strategists say positioning, or bets on VIX, remain subdued and said that they are expecting stocks to see similarly muted action, barring any new Twitter flare-ups from Trump. ‘This is consistent with our last report, where we pointed out that pullbacks are likely to be less severe compared to those last year,’ the analysts said.”
The above is pretty typical of what I read about volatility. There is almost always a reference to its “historic average,” and some inference that it is below that number and should at least move back toward it. But the reality is that volatility is extreme-seeking.
What does that mean?
It means that low volatility is not a forecast for average volatility, or “subdued” volatility as the JPMorgan strategist suggests above, but instead it is a forecast for high volatility. Just as very high volatility is not a forecast for average volatility, but instead a forecast for low volatility.
VOLATILITY AND RISK
In the asset management business, there is a very popular model called VaR — value at risk. There are several flavors of VaR, but most work the same way. When volatility is low, they suggest taking large position sizes and when volatility is high, they suggest reducing risk by taking smaller position sizes. But in reality, you should do the opposite.
When volatility is low, as it was in October, you should be extremely cautious and take very small position sizes. The low VIX signals too much complacency in the market. When volatility is very high, as it was in late December, you should increase position sizes, because there is too much fear.
The chart below shows the SPX (S&P500, green) overlaid with the VIX (red) for a visual picture:
Trade wars, Trump tweets and a back-pedaling Fed will make for an interesting next few months. There is a Fed conference about inflation June 4-5, an FOMC meeting June 19, an OPEC meeting June 25-26, followed by a G-20 meeting June 28-29. Needless to say, there will most likely be a great deal of market action around the headlines that come from the meetings.
June might just turn out to be something other than the beginning of the summer doldrums.