Wednesday, June 1, 2011

A moderate case of the jitters


As a follow-on to yesterday's post, here is another way to measure how pessimistic the market is, and how much actual deterioration in the fundamentals there has been. The chart takes the Vix index of implied equity volatility and divides it by the yield on 10-yr Treasuries. The higher the Vix, the higher the degree of market uncertainty and fear; the lower the yield on Treasuries, the weaker the economy is perceived to be. So a higher ratio is bad, and a lower ratio is good.

This ratio has recorded some pretty spectacular spikes over the years, but today's level is only moderately elevated (6.26). This jibes with the other indicators I showed yesterday, with the conclusion being that the market is definitely concerned about the outlook and the fundamentals, but not to any alarming degree. I could say the same thing for Euro 2-yr swap spreads, which at 52 bps are definitely above average, but not by a lot.

In Don Luskin's book "I Am John Galt", the section on Alan Greenspan makes the interesting observation that Greenspan was pursuing a stealth gold standard as Fed Chairman from 1987 through the late 1997. The Fed funds rate fairly closely tracked the price of gold, which is what one would expect to see if indeed the Fed were on a gold standard. During that same period, inflation was fairly low and relatively stable, and there was a noticeable lack of market panics. But after 1997 the Fed started raising the funds rate even as gold and commodities declined. Greenspan apparently switched from his Randian focus on gold and adopted the more popular Phillips Curve vision of inflation. Phillips Curvers were very worried in the late 1990s that the U.S. economy was "overheating" and that too much growth would prove inflationary. The facts proved them and Greenspan wrong, however, since the economy slipped into recession in 2001 (as it usually does when monetary policy becomes too tight) and inflation fell to very low levels. In fact, we came pretty close to experiencing outright deflation in 2002 and 2003. That put the fear of God into Greenspan, since he subsequently decided to pursue an extraordinarily accommodative policy for the next several years, and that contributed to inflate the housing bubble. With monetary policy cut loose from the anchor of gold, is it any wonder that the Vix/10-yr ratio has experienced such extreme volatility in recent years?

8 comments:

Bill said...

Scott,

It sure seems like it's been a while since we've had an uptrend in any of the important data. Doesn't this signal a possible recession?

Dr William J McKibbin said...

The Federal Reserve would be wise to announce a $3-5 trillion QEIII plan immediately -- the effects of such an announcement would be spectacular for the markets, and the Fed can always curtail QEIII well ahead of the target amount once the economy turns around -- QEIII appears imminent and quite necessary at this point...

Public Library said...

Nothing beats a gold standard so long as it is not stymied by the government.

Why we charge 7-12 men beholden to the banks to manage our money is beyond my ability to comprehend.

Dr W. QEIII is a nail in the coffin, not a divine offering from the Gods.

Dr William J McKibbin said...

Hi Public Library, a $3-5 trillion QEIII would not be a nail in my coffin -- not at all -- those who hold overvalued assets such as bonds or government pensions will dislike a QEIII -- those with undervalued assets such as reliable (and local) rent-earning real estate and dividend-paying stocks will love QEIII -- therein likes the true paradox of the US economy by the way...

Scott Grannis said...

Bill: recessions don't just happen out of the blue, and the economy doesn't turn south unless it faces some pretty strong headwinds. Monetary policy is not tight enough to be a serious headwind, but easy money is sapping confidence so it is contributing to slow growth. Fiscal policy is not stimulative at all, since it is sapping most of the economy's strength. But it's only going to get better and the only question is when and by how much. I think that cutting spending will prove very stimulative because it will boost confidence and trump the argument for higher taxes.

So the economy muddles along, but it doesn't fall into a recession. The thing to watch for is positive signs of growth.

Public Library said...

Dr W. Only so long as the genie doesn't escape the bottle but my belief is the Federal Reserve has lost control of this rudderless ship. We are in new territory where the Fed can make a fresh round of new mistakes.

Ali said...

Is this leading or lagging vs GDP, equity market performance etc, assuming thats what you're trying to anticipiate.

Because if you look at the chart, the same low readings were evident pre 2008, pre 2000 crash, pre LTCM etc etc. If anything, it shows complancency.

Scott Grannis said...

I'm not trying to argue here for whether this indicator is leading or lagging. Rather, I'm arguing that the level of concern that it is registering is not particularly high, and does not match all the hoopla and bearishness that seems to be out there. So the market is probably overreacting and oversold at this point.