It’s Hard To Quit.

Here’s something I wrote the other day about the marked divergence between policy/geopolitical uncertainty and market-based measures of “fear”:

By outsourcing the responsibility to respond to exogenous geopolitical shocks to central banks, markets have relieved themselves of their duty to price risk. It isn’t really correct to say that markets are “mispriced” given elevated policy/geopolitical uncertainty. Rather, it’s more accurate to say that by virtue of their efforts to condition markets to expect increased central bank accommodation at the first sign of turmoil, policymakers have simply removed the very concept of risk from the equation, thus obviating the need for markets to price it.

This of course means that by definition, “central bank mistake” is the only risk that really matters for markets (short of a catastrophic armed conflict). Because – and this is key – if central banks are the ones removing all the risk, well then nothing is more “risky” than a mistake by those central banks.

That said, BofAML finds that “the majority of vol spikes over the past years have taken place during periods of geopolitical uncertainty.

The bank’s Barnaby Martin goes on to warn that, in case you haven’t noticed, “geopolitical risk is back.” Here’s the chart:

Risk

So now, more than ever, it’s important that central banks are able to function in their role as vol. dampeners. Here’s BofAML again:

QE programs around the globe have had a clear target: to reduce uncertainty and dampen market volatility. As we have highlighted before, every time the Fed embarked on the different phases of its QE programme, credit implied vols declined significantly (chart 6). On the other hand, during periods of no monetary easing or when the market started pricing the possibility of easing policy removal (tapering tantrum and the subsequent tapering phase) implied vols advanced (chart 6). Same happened in the case of the ECB: implied vols have re-priced lower post the announcements of the PSPP and the CSPP.

QE

The problem is that if you wait long enough to remove crisis-era policies, another crisis will invariably come calling (that goes back to the idea discussed in “Nosebleed“, namely that if the “state of exception” is extended for long enough, it becomes permanent).

If you haven’t normalized by the time the next crisis hits, you won’t have any room to lean against the volatility that accompanies it. And the very last thing you’d want to do in the midst of a geopolitical shock is try to start rolling back the accommodation you put in place to combat the previous crisis. Because then you’ll be actively contributing to the vol. spike (by selling assets or letting them roll off the balance sheet) and passively contributing to it as well by removing the “put” that incentivizes investors to buy dips and suppress volatility.

So think about that and then consider the title of the BofAML piece cited above…

Why

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