Monday, December 28, 2009

Fear, uncertainty and doubt are way down



This chart plots the implied volatility of equity and T-bond options, and thus is a good proxy for the level of fear, uncertainty and doubt (FUD) that inhabits the market. The market has effectively breathed a huge sigh of relief this past year. Implied volatility hasn't yet returned to levels that would be consistent with tranquil economic and financial conditions, but it's coming into view.

Part of this improvement is due to the shifting winds of politics; a good portion of Obama's destructive policy agenda (e.g., cap and trade, card check) has been derailed, while others (healthcare) have received considerable push-back from members of his own party. In fact, the hard-left policy agenda he has been pushing increasing appears to be out of sync with the desires of the electorate. Back in early March the market looking with great fear and trembling at the prospects of a fiscal train wreck culminating in a sweeping expansion of government powers and awesome tax increases; the worst-case scenario which seemed likely then is much less likely now.

Part of the improvement can be chalked up to emergency measures on the part of Treasury and the Fed which helped restore confidence in the banking system and averted a debilitating deflation. This in turn provided the necessary backdrop for the economy to pursue its own process of recovery.

I view this improvement in financial conditions as one of the key economic fundamentals supporting an optimistic outlook for growth in the coming year. Markets abhor FUD and risk in general, and that explains why economies generally have great difficulty posting healthy growth when conditions are highly uncertain. The greatly reduced level of perceived risk that is evident in this chart should translate directly into improved growth conditions, since it means reduced transaction costs, lower borrowing costs, and greatly reduced systemic risk.

5 comments:

alstry said...

Dec. 28--BOONEVILLE -- Booneville city employees will see a 10 percent pay cut when they open their first pay envelopes in 2010.

Hawaii hotel and restaurant employment is at its lowest level in six years and workers are making less than a year ago....It was the first time wages fell in at least 10 years, according to labor department data.

The Cochrane-Fountain City School Board voted to raise the district property tax levy by 14 percent for 2010, a figure that tops the region in increases for local major taxing authorities.

Scott:

With the rapid decline in tax receipts plus ever growing deficits....and ostensibly getting worse on the margin....what impact on the current recovery will a dramatic increases in taxes have?

Thanks.

Rick said...

Hi Scott, I do not think that the lower VIX means the stock markets are projecting solid economic growth. Instead, I think that the lower VIX means that equity investors believe that their investment risk has reverted to a normal range of possibilities that include good and bad outcomes. That is a good thing.

Scott Grannis said...

Rick: I never intended to imply that a lower VIX says anything about the market's outlook for growth. A lower VIX is conducive to growth, since it reflects a reduced level of systemic risk.

Chris said...

Scott: I don't pretend to know much about the debt market so I wanted to point you to an item I read on Zero Hedge regarding their outlook for next year and I was hoping you would share your thoughts. This sounds pretty grim.

Thanks,
Chris

http://www.zerohedge.com/article/brace-impact-2010-private-demand-us-fixed-income-has-increase-elevenfold-or-else

Scott Grannis said...

Chris: Thanks for the link to the Zero Hedge article. The numbers do look scary. But I would note that by his calculations, net issuance next year will be essentially the same as it was in 2007 and 2008. Since we survived those years without any major increase in interest rates (10-yr Treasury yields fell over 100 bps during that time), there is no reason in principle to think that next year will be a catastrophe. It's very often the case that big increases in government debt issuance occur alongside big reductions in private debt issuance (the crowding out theory has some basis in fact).

I am unaware, in any event, of any evidence which links net issuance to the changes in the level of interest rates. Indeed, it's not rare at all to see a big increase in net issuance coincide with declining interest rates. Falling yields are a sign of strong demand for bonds, and issuers typically respond to a strong bond market by issuing more.

Nevertheless, I do think we will see Treasury yields rising next year, and not just because of a big increase in net issuance. Inflation and growth and Fed tightening will play a role.

Finally, I would note that it's no secret that issuance will be huge next year. The market has presumably digested this information long ago.