‘Throw Us A Little Volatility Here, We’re Begging You’

There’s been no shortage of shrieking from the peanut gallery about the extent to which financial conditions have steadfastly refused to tighten despite multiple Fed hikes and token nods at balance sheet normalization.

Stubbornly loose financial conditions have of course contributed to the continued inflation of bubbles in financial assets and to the draconian suppression of volatility.

Of course low volatility is self-feeding and the behavior it encourages itself encourages still more of the same behavior in a loop that embeds ever more risk into a system that is deceptively stable. In other words, there’s a certain extent to which the low volatility regime is paradoxical, as the longer volatility remains suppressed, the greater is the risk for a violent snapback. If you want to read more on this, we strongly encourage you to check out the following two posts:

Of course if you were looking for equity vol., you won’t find much of it this morning. Indeed, the VIX collapsed to nearly an 8-handle on the heels of earnings beats from multiple market bellwethers.

VIX

Read below as Cameron Crise explains why the Fed needs to “throw us a little volatility” before it’s too late…

Via Bloomberg

Hey Fed, Throw Us a Little Volatility Here, Please

Wednesday sees the latest installment of the Fed laying the groundwork for a shift in its balance sheet policy, probably in September. Although the Fed continues to miss its arbitrarily defined inflation target, the Bloomberg financial conditions index is now at easiest level in a decade. That episode ended rather badly, and the Fed would do well to inject a little volatility into proceedings before the market does it for them.

  • The Fed’s halting journey toward balance sheet normalization makes Odysseus’s trip home seem like a speedy jaunt on the hyperloop in comparison. A desire to avoid shaking up the Treasury market appears to be driving this deliberate approach
  • An apparently heightened concern over low inflation figures has spurred the latest easing in U.S. financial conditions as the market assumes that the Fed will do much less tightening than envisaged by the dot plot. We’re now at the easiest level of financial conditions since May 2007
  • There is nothing wrong a priori with easy conditions and low volatility. However, the degree to which conditions have eased even as the Fed has normalized policy is unprecedented. R* says that policy rates are close to neutral. Financial markets are saying that they are very easy indeed
  • The transmission mechanism of monetary policy is such that the Fed and other central banks have a lot more direct influence over financial markets than they do over inflation
  • The last two economic growth cycles ended as a result of malinvestment gone awry. Overly easy policy was at least partially to blame in both instances.
  • As discussed earlier, low volatility tends to cluster and feed on itself. Barring a shock or other catalyst, it can continue for longer than is sensible
  • The Fed has two choices: a little volatility now (via a controlled experiment to keep normalizing policy despite tepid inflation) or a lot of volatility later (when the current regime goes awry, as all economic and market cycles eventually do)
  • For the long-term health of both the economy and the market, let’s hope they eventually choose the first of these two options
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