How Bad Would It Have Been Without The Xanax?

Discussions about the disconnect between policy uncertainty and market-based gauges of implied volatility are complicated by a laundry list of factors, not the least of which is that the former is often measured by news-based indicators.

And yet, there’s something irresistible about charting, analyzing and otherwise pontificating around the vast disparity between, for example, the VIX and the Economic Policy Uncertainty Index. Or, if you like, rates vol. and variants of the EPU.

If you’re new to this debate, it’s not hard to understand why it’s so intriguing. Here’s one such chart:

There are all manner of variations on the Global EPU available here, and you may also encounter a news-based trade policy uncertainty index which you can explore here.

If you spend some time with the data available at those links, you can construct different versions of the above visual, replacing the Global EPU with, for example, country-specific gauges. You can also replace the VIX with 3M10Y (for rates vol.) or indexes of FX vol. from JPMorgan or Deutsche Bank.

In almost all cases, you’ll come away with something that looks vaguely like the chart above – that is, a discernible rise in policy uncertainty disconnected from market-based measures of volatility in recent years. That disconnect was most glaring in 2017 during the low vol. bubble, and multiple attempts were made to explain it.

Generally speaking, the explanation is that central banks have succeeded in suppressing cross-asset volatility by perfecting the art of forward guidance which anchors expectations, thereby enhancing the effect of rate cuts and asset purchases. It was forward guidance which helped “buy the dip” morph from a derisive meme about retail investors into a viable (indeed, an almost infallible) trading “strategy”.

In 2020, central banks’ capacity to preserve the gap between news-based policy uncertainty and market-based measures of volatility will be tested anew, something Deutsche Bank spends a bit of time discussing in their year-ahead outlook for the US economy.

“We see two critical sources of uncertainty over the next year. First, trade policy uncertainty has been near record high levels”, the bank writes, referencing the above-mentioned TPU index. Donald Trump’s “Phase One” deal with China should help mitigate some of that uncertainty but you don’t have to be an analyst (or a soybean farmer) to be skeptical. Here’s Deutsche Bank’s Matt Luzzetti (the bank’s chief US economist):

Despite reaching a Phase One deal with China, uncertainty in this area is likely to remain elevated with longer-term trade issues with China unresolved and the US Administration indicating that it is considering similar investigations into trade with Europe. Fed staff research has found that spikes in trade policy uncertainty over the past two years have already shaved about one percentage point from the level of GDP.

And then there’s the election. Remember, irrespective of your own personal views on the long-term merits of redistributive policies (we would argue, for instance, that removing the student debt and healthcare premium albatrosses from the necks of the people with the highest marginal propensity to consume will be a boon to an economy that lives and dies by consumption), in the near-term, a rolling back of the tax cuts would prompt a dramatic reassessment of S&P earnings expectations. That, in turn, would invariably mean a selloff in US equities.

(Goldman)

As Deutsche’s Luzzetti goes on to note, “historically, economic policy uncertainty in general–and in particular, uncertainty related to tax policy–has been elevated in presidential election years versus non-election years”.

There’s good reason to believe that dynamic could be even more pronounced in 2020, especially if Bernie Sanders or Elizabeth Warren were to close the gap with Joe Biden.

(Deutsche Bank)

“Given the potential for very divergent policy landscapes depending on the outcome of the 2020 election, it appears that economic policy uncertainty should remain elevated through next year, even if the fog of the trade war begins to dissipate”, Deutsche Bank goes on to say.

The interesting bit (in the context of the disconnect between policy uncertainty and market-based measures of volatility) comes when Luzzetti writes the following with regard to the impact of monetary policy in environments of elevated uncertainty:

Monetary policy’s efficacy in the presence of elevated uncertainty is an important consideration for the growth outlook over the next year. As discussed in recent research from the St. Louis Fed, “monetary policy is less effective in a high-uncertainty environment.” Our own analysis that accounts for an interaction term between the level of economic policy uncertainty and financial conditions as measured by the Chicago Fed FCI, reaches a similar conclusion. That is, easier financial conditions tend to have a more modest impact on growth when economic policy uncertainty is high. As such, while we see monetary policy and financial conditions supporting above-potential growth over the next year, this impact may be dampened by elevated domestic policy uncertainty.

You might be inclined to suggest there’s nothing particularly notable in that passage, but I would beg to differ. For one thing, as the comparisons between various news-based gauges of policy uncertainty and market-based measures of implied vol. mentioned above will attest, monetary policy has been extremely effective at anchoring volatility over the past several years. Of course, something like, say, FX vol., isn’t a proxy for the broader economy, but heightened volatility in markets does feed into financial conditions, which in turn can affect real economic outcomes.

But beyond that, one might be inclined to think that monetary policy would be more effective in the presence of elevated uncertainty in the same way that a Xanax (or pick your favorite benzodiazepine) could be described as “more” effective in the presence of a panic attack.

Sure, elevated policy uncertainty could be seen as blunting or otherwise offsetting the impact of rate cuts and dovish forward guidance, but then again, accommodative monetary policy is in many cases “prescribed” to offset heightened political uncertainty. In the same way that a panic attack could spiral into an acute (or even life-threatening) situation in the absence of Klonopin, acute bouts of political turmoil and trade frictions could lead to dangerous spikes in cross-asset volatility in the absence of monetary accommodation.

Remember, the relationship between volatility and market depth is very strong and nonlinear. As JPMorgan’s Marko Kolanovic wrote nearly a year ago, “market depth declines exponentially with the VIX”.

(JPMorgan)

“Given that an increase in volatility often results in systematic selling, this relationship is the key to understand market fragility and tail events”, he wrote.

This is similar to how panic attacks spiral. Anxiety begets nausea, which begets more anxiety, and without a circuit-breaker, a crisis ensues.

In short, we will never know how markets would have reacted to the debt crisis in the periphery, or to the EM turmoil in 2015, or to the rise of populism in Europe, or to Trump’s various trials and tribulations over his three-year tenure as master of the universe, in the absence of monetary policy accommodation, just as we will never know how bad a panic attack treated with benzodiazepines would have been in the absence of a palliative.

In that sense, we may never know just how grateful we should be to monetary policy.

Food for thought as we come off a year dominated by central bank-inspired volatility suppression and enter a year where monetary policymakers’ mettle will likely be tested again and again, against an increasingly empty medicine cupboard.

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