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The Vix index (implied equity volatility) has fallen to its lowest level since the onset of the panic selloff in equities which began last May (which in turn was driven by the belief that the economy was on the cusp of a double-dip recession). Equities have not completely recovered from that episode, however, but they look to be in the process of doing so, and a declining level of fear is one important driver of the rally. As the top chart shows, the implied volatility of T-bonds, as measured by the MOVE index, fell dramatically this week. This is also helping equities, and let me explain why.
It would appear that the market has reached an almost unanimous opinion that the Fed will implement a second round of quantitative easing early next month, this time with the objective being to pull down 10-yr Treasury yields and keep them down for a considerable period. I think this is foolish and unnecessary, as I argued in yesterday's post, but those concerns are irrelevant for now. If one believes that the Fed will do all in its power to suppress 10-yr Treasury yields in an effort to avoid deflation and to spur the economy, then it makes sense that the implied volatility of Treasury options should fall to very low levels. After all, isn't the Fed going to practically guarantee that yields won't rise? And since they can't fall a whole lot more than they already have, this means that we are now (supposedly) at the beginning of a long period of low and stable yields (though I'm not necessarily agreeing with this). So options become very cheap, because uncertainty has all but vanished.
As I argued yesterday, the important thing about the Fed's promise to do anything it takes to avoid deflation (and maybe even to push inflation up) is that this all but eliminates the risk of deflation if done in convincing fashion. Deflation fears have been lingering for quite some time now, but now they are vanishing. When you take deflation risk off the table, suddenly the expected future value of all cash flows goes up: that's why the stock market is going up.
At this point it is probably not even necessary for the Fed to proceed with QE2. Promising in convincing fashion that they would do it if necessary is enough. And the market is now convinced. That automatically brightens the future, even though it leaves alive the concern that they will push inflation too high.
14 comments:
Scott,
Good post. Although I believe no QE action in November would likely trigger a stiff correction, that is probably all it would be. The election results are also somewhat priced in although the Senate changing hands might be a mild positive surprise.
I am sympathetic to the views of Pub and others on the risks of printing too much money. When the inflation genie gets out, its very hard to get him back in the bottle. QE adds to the risk of overshooting. Yet, we have an underperforming economy with much pain among the unemployed. Politicly a performing economy is necessary. Maybe some QE (or the threat of it) can help bring that about.
Deflation fears seem to persist but what about limit up today in grain trading? Soaring inflation in agricultural prices is a very real concern for restaurants. The economy needs solid structural changes in tax policies and government austerity for sustained private sector growth. QEII is instant gratification and should be moored along side the Queen Mary in Long Beach in retirement.
Commodity markets seem to be acting rationally given the Fed's promise to reflate. It's like the Fed has given the market a free put. That gives you the ability to be long without much risk. Inflation speculation has been with us for awhile and is now likely to continue.
Commodities markets are responding to global demands. What happens in the US is becoming less and and less important--remember there are 2.5 billion Indians and Chinese with rising incomes. They buy, they demand, and prices rise.
If we try to fight global commodity inflation by tightening a monetary noose around our own neck, we will end up like Japan or worse.
Milton Friedman called for QE when an economy lags, and there is deflation and you hit the zero bound. We are there now, or close.
My own hunch is that the CPI overstates inflation by 1-2 percent, due to the Internet, dollar stores, and incredible increases in consumer options and productivity.
Cell phones, Craigslist, Ebay, Amazon--you can search nationally, or globally, for products and services. For free.
As for domestic inflation, the question is can we generate enough of it? Milton Friedman said monetary expansions first leads to growth, then with a delay it leads to inflation.
If we pump money into the system really hard, we still might have wait a couple years to see inflation, according to MF. I hope the banks can hold on for that long--they are suffering from deflation and depression in real estate markets.
Guys, for forget about commodities. Weather, OPEC, rising consumer demand for jewelry in India and China all impact commodities--the US money supply is a small player on a crowded stage.
Grain prices are also responding to poor wheat harvests in Russia...exports have been suspended. Also, the corn harvest forcast in this country was reduced recently due to weather.
BTW, here is an idea from another Univ. of Chicago economist, John Cochrane.
It is heartening to see so many "right-wing" or "conservative" economists opening up to possibilities for monetary expansionism.
This is from a blog by Davis Beckworth:
What Do John Cochrane and Milton Friedman Have In Common?
Yes, they are both well-known economists from the University of Chicago, but there is more. Milton Friedman in the early 1990s called for the Federal Reserve to start targeting the expected inflation rate implied by the difference between the nominal treasury yield and the real TIPs yield. He made this call in his book Monetary Mishief.* Now John Cochrane is advocating this approach too:
[T]he Fed can target the thing it cares about – expected CPI inflation – rather than the price of gold. To do it, the Fed can target the spread between TIPS (Treasury Inflation Protected Securities) and regular Treasurys, or CPI futures prices. Here’s a simple example. Investors buy a CPI-linked security from the Fed for $10. If inflation comes out to the Fed’s target, they get their money back with interest, $10.10 at 1% interest. If inflation is 2 percent below target, the Fed pays $2 extra -- $12.10. This pumps new money into the economy, with no offsetting decline in government debt, just like the helicopter drop. If inflation is 2 percent above target, investors only get back $8.10 – the Fed sucks $2 out of the economy at the end of the year. If investors think inflation will be below the Fed’s target, they buy a lot of these securities, and the Fed will print up a lot of money, and vice versa."
I still contend we are undermeasuring inflation, possibly by 1-2 percent.
Notice that Cochrane and Friedman are not concerned about the price of commodities or gold.
when does fear subsiding prices rising ever lead to a crash? does it?
Scott, we'd like to use some of your charts in a presentation. What is your copyright policy? Thanks.
Re copyright policy: Acknowledging the source would be fine.
Scott, can you explain to me how the "subscribe" function works on your blog? I use both a Mac desktop and a Mac laptop to access your commentary....will the subscribe function in some way enhance the access?
I am not he very tech savvy....THANKS for your patience.
After breaking support on friday the VIX this AM gapped down on the open and is trading under 20 for the first time April and the early euro-collapse fears. The Fed's QE bazooka is continuing to affect the volatility premiums.
Also, the spread between the 10 & 30 yr T-bond yields continues to widen. I am no expert on this but in my experience this tends to happen nearer bottoms than tops.
Fear is continuing to decline. One cannot rule out a correction somewhere in here but it appears to me that is the worst we get short term. I still think the market is higher by yearend.
John-
If the Fed acts confidently, announces higher inflation targets and brings on the QE2, this recession is dead.
The other good news is that inflation is dead for two years. We get a good solid rally out of this, I think.
We could even get a secular rally, ala 1982-2000, if tax and reg policies come into line.
zumbador: Re subscribing. I'm not highly tech savvy either. Perhaps someone could explain how subscribing works. There are a lot of ways to do it apparently.
re subscribe:
I'm not an expert either, but to the best of my knowledge subscribing facilitates an "RSS" feed. Basically a way to notify some other interface when an update has been posted to this blog. Someone might have a news reader that aggregates feeds from multiple sources (including this blog), so he/she can look in one place to see any updates to everything they are interested in. Looks like you can also use it to get RSS like notices sent to an email. FWIW, I'm barraged by enough streaming info. Checking sites when I feel like seems plenty to me.
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