Monday, September 14, 2009

Implied volatility update (2)

For the offer of a dinner in Chicago I probably won't be able to accept (no reason at this time to go there), I'm happy to provide this updated chart on the implied volatility of stock and bond options. And with it, to elaborate on my current investment thesis.

The story is still the same as it was a few weeks ago, except that vol has declined in both markets. Interestingly, declining volatility has been good for stock prices, but T-bond yields have drifted up a bit. The main point of this chart, however, is that while vol has dropped quite a bit from the all-time highs of the past year, the current level of volatility in both markets is still well above average and still way above the lows we have seen in the past two decades.

In my previous post I inferred that this relatively high level of nervousness and uncertainty was an outgrowth of the tensions that have shown up in sensitive asset prices. Stocks have been rallying for the past six months and commodity prices are up strongly across the board, suggesting that both the U.S. and the global economies are in recovery mode. Not everyone is prepared to accept this, however, and for a variety of reasons. Those who understand that the Keynesian stimulus that has been applied by the Democrats is more likely to impede the economy's progress rather than help it have real trouble seeing anything like a healthy recovery on the horizon. Those who worry about the coming wave of commercial real estate defaults, interest rate resets on mortgages, and the high unemployment rate, are convinced that this recovery is a false dawn that will soon be replaced by another slump. Those who think of inflation using a Phillips Curve model are urging the Fed to keep the pedal to the metal if only to forestall another slump. Still others worry that inflation is baked in the cake but that any attempt by the Fed to raise rates will kill the economy.

I think this adds up to an equity market that is still cheap and probably priced to another slump, and a bond market that is up against the limits (i.e., in terms of the steepness of the yield curve) allowed by the Fed's stated intention to keep short-term rates very low for a long time (see prior post for more details). I shouldn't leave out credit spreads, since while they have declined significantly, they are still at levels that in the past have been consistent with recessionary conditions; this also supports my contention that the equity market is still cheap.

The tensions in the market are likely to fade with time, as evidence accumulates to support either the growth case, the double-dip case, and/or the inflation case. In my mind, the sensitive and leading indicators strongly support the growth case (and have since late last year), while bad fiscal policy will act to limit growth to only 3-4%, far less than we might otherwise experience if all the stars were aligned correctly. Standing with the majority of supply-siders and Austrian economists (who are, however, in a distinct minority overall), I am fearful that the Fed is not going to be able to withdraw its liquidity injections in a timely fashion (and truth be told, it seems to me they should have already started), so I believe the inflation case will gradually reveal itself and hasten the day the Fed has to start raising rates.

And when they do, I won't be surprised to see that they are slow to react, and reluctant to tighten as much as they should, and that will add fuel to the inflation fires. That was the story of the 1970s in a nutshell, and it looks like history could repeat itself, although I doubt we'll see double-digit inflation like we did then. Nevertheless, as soon as the Fed or the market begins to worry about tightening, the bond market is going to be in for a very unpleasant shock. This may send some shock waves through the equity market, but if the Fed is even just a little bit close to doing the right thing, higher interest rates could be a very encouraging development, since they would reduce the degree of inflation uncertainty, improve confidence in the dollar, and enhance the outlook for investment. Higher bond yields in the midst of a recovery might also give legs to the argument that we should cancel what remains of the faux-stimulus plan and concentrate our efforts on limiting spending.


Brian said...

UK Telegraph reports "Both bank credit and the M3 money supply in the United States have been contracting at rates comparable to the onset of the Great Depression since early summer, raising fears of a double-dip recession in 2010 and a slide into debt-deflation."

Is this a Phillips interpretation of the data?

Cabodog said...

I'm sure there's a thank-you dinner awaiting you wherever your travels take you.

Scott Grannis said...

Brian: I just left a comment on the "Market expects an easier Fed" thread about this, and plan to post some charts. Short answer is that people are taking the negative growth out of context.

MW said...

"I am fearful that the Fed is not going to be able to withdraw its liquidity injections in a timely fashion (and truth be told, it seems to me they should have already started)"

In fairness to the Fed, they have been reducing the size of some of their lending programs, so they have started. They may not be reducing them as fast as you like, of course!

MW said...

Should have added this to the last post.

If the level of inflation or the vol of inflation picks up, I'd expect implieds to pick up (in FX, rates and equities). Any thoughts or comments?

Scott Grannis said...

MW: You are correct about the reduction in some lending programs. But the size of the balance sheet has not shrunk. Reductions in lending programs have been offset by increased purchases of Treasuries and MBS.

As for inflation and vol: I think it depends on how it unfolds. Inflation has a nasty habit of sneaking up on people. The market is not going to start fearing inflation overnight. It will take a long time. Most people will probably ignore the higher inflation numbers, arguing that things will turn back down in the future since the economy remains weak. Much the way a lot of folks have been reluctant to believe that the equity rally since March is for real.

It might take years for inflation to get bad enough for the Fed to take drastic action, and then vol would go to the moon. Think of what happened in the year or two following Volcker's decision in late 1979 to slow the growth in the money supply. Panic didn't set in until late 1980, by which time inflation was already turning down. The dollar started to skyrocket in early 1981.

MW said...

"Think of what happened in the year or two following Volcker's decision in late 1979 to slow the growth in the money supply..."

Thanks Scott. Is there anything you'd recommend reading on Volcker's tenure at the Fed? I'm familiar with the broad brushstrokes but not the details.

Scott Grannis said...

You can find lots of things on the internet that deal with Volcker and monetary policy. If you want a very instructive book on a lot of subjects, particularly supply-side economics, I highly recommend Jude Wanniski's "The Way the World Works." He has at least one brief discussion of Volcker, but also deals with the interaction of monetary policy and fiscal policy in a way that few other people do.

j said...

Scott, thanks for the update of the vol charts and commentary. You have a standing invite here in Chicago, I hope you can make it through town in the coming year. Thx

MW said...

Thank you for the recommendation. There is a lot of rubbish out there (e.g. Bob Woodward's "Maestro") as far as books on central banking goes, hence my question.