Taking the pulse of uncertainty

As I gear up for making another round of fearless forecasts (due out next week), it's important to first take the market's pulse. In this post, I consider how uncertain the market is concerning the outlook for the future. This chart compares the implied volatility of equity options and bond options. Implied volatility is a good measure of now much uncertainty the market perceives in the future, since it is a measure of how expensive options are (buying options is a way to reduce your risk exposure when you are unsure about the future). I also note that when uncertainty is highest, this tends to correspond to or signal market extremes. For example, the peak in the MOVE occurred in early Oct. '08, about three months before 10-yr Treasury yields hit their post-Depression low of 2.06%. The peak in the Vix occurred a few weeks later, preceding the equity market's ultimate bottom in early March by just over four months. The Vix was trading over 20 for about a year prior to the market's 2000 peak, meaning that a lot of people were nervous that prices were moving too high, and that turned out to be the case.

The Vix index is now trading at just about the lowest level we have seen since before the great crash of 2008. It's still higher than what we would expect to see in relatively calm conditions (e.g., 10-14), but not by much. Thus it would seem that the market is not greatly concerned about the outlook for the market or the economy. To be sure, optimism is in short supply these days, but when you combine today's skeptical market with implied volatility that is only moderately elevated, the result is like a sort of "consensus" that things aren't going to be greatly different in the future than they have been in the immediate past, namely: economic growth that is plodding, unspectacular, and insufficient to make much of a dent in the unemployment rate. The outlook for tax rates has been resolved, and that certainly helps reduce uncertainty, but there are still large uncertainties surrounding fiscal policy at the federal, state and local levels, and the still-unresolved debt crisis in the eurozone.

The MOVE index (the implied volatility of Treasury debt options) has risen in recent months, but it is still substantially lower than it has been for most of the past three years. This is to be expected, given the recent surge in yields on Treasury debt (10-yr yields are up almost 100 bps since October), and it is proportional in magnitude to what we saw when 10-yr yields surged 160 bps in the first few months of 2009. The most uncertain thing in the financial markets at this point would thus appear to be the future level of Treasury yields. I would note here that despite their recent rise, Treasury yields in general are still very low from an historical perspective. The only time in modern history that they have been lower, in fact, is during the Depression and deflation of the 30s and 40s. In my view, the rise in implied Treasury volatility is not sufficient to signal a market that has gone to an extreme (i.e., it does not suggest that yields are vulnerable to a reversal). I think the rise in yields reflects a market that has shifted its focus from one of expecting a double-dip recession to one that is trying to judge how strong or weak the expansion is likely to be.

A return to something characterized as more "normal" can be seen in the Bloomberg Financial Conditions index (below), which is "the number of standard deviations that current financial conditions lie above or below the average of the 1994-June 2008 period." Reduced uncertainty and volatility are generally supportive of economic growth, since at the very least they remove artificial barriers to growth. The return of "normal" conditions to the financial markets is a reflection of the return of both liquidity and confidence, and that is supportive of growth going forward, but not a guarantee.

I think this all paints a picture of a market that has ruled out a double-dip recession and an economic boom, but a market that assumes that a continuation of relatively slow growth (given the stage of the business cycle) is likely. This same outlook can also be found in the Fed funds futures market, where prices imply that the Fed is quite unlikely to raise the Fed funds rate before December of next year—thus ruling out a boom and assuming the continuation of slow growth that requires lots of help from monetary policy.