Back in February, we introduced readers to the idea that the Global Economic Policy Uncertainty Index can be used to proxy what BofAML has called “politicians’ implied vol”.
That’s a pretty liberal interpretation of the gauge. It’s actually an index quantifying the frequency of stories in newspapers which mention uncertainty about economic policy, but it’ll work.
BofAML’s European credit derivatives team likes to plot that index against rates vol. in order to demonstrate the extent to which central banks have managed to suppress market-based volatility, even as geopolitical turmoil and uncertainty around the evolution of policy proliferates.
The bank prefers rates vol. because “no other measure best captures the cumulative effect of QE and the effect of forward guidance [as] the former accumulates assets and the latter anchors uncertainty about the future path of funding costs and the potential risk of re-pricing across the fixed income world”, to quote a February note.
Of course, another way to visualize the same dynamic is simply to plot the index against the VIX.
And while many readers will have seen this before, we wanted to highlight it again given that 2019, perhaps more than any other year post-crisis, has been defined by central banks engaging in a coordinated, global effort to tamp down market-based measures of volatility in the face of another surge in “politicians’ implied vol”, to use BofAML’s vernacular.
“Unsurprisingly, the [EPU] has shot sky high over the past decade and yet it’s had surprisingly little effect on investors”, Bloomberg’s Lu Wang recently wrote, adding that “it all makes a kind of sense when considered alongside what central bankers have been doing”.
Right. And BofA’s Ioannis Angelakis underscores the point in his year-ahead outlook. “Once again, central banks are trying to safeguard the economic outlook while political risks threaten to derail the achievements of years of accommodative policies across the globe”, he writes, describing the scatterplot below.
Obviously, there have been periods during which volatility has returned, but central banks have largely succeeded in beating back the turmoil.
Some of the calm in markets is attributable to a placid economic environment – an even Greater Moderation, if you will.
One of the biggest questions in 2020 will be whether central banks’ limited capacity when it comes to additional rate cuts and asset purchases will force policymakers to lean increasingly on forward guidance to offset assumed political volatility – and, if so, whether their communication skills will be up to the task.
“2019 has been about more rate cuts and more QE. 2020 will be the year when central banks need to confirm their ability to dampen tail risk and support the global economy”, BofA’s Angelakis says, on the way to cautioning that “monetary policy communication mishaps will be key in 2020 [as] it will be a fine balancing act to shift the focus from rate cuts back to forward guidance”.