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The Coming Financial Volatility

LONDON – Bond investors are from Mars, and central bankers are from Venus – or so suggests the bond market’s negative reaction to signals that the exceptional monetary-policy accommodation of the last decade is winding down. Risky asset markets, however, are ignoring the red flags that the bond markets are waving. Are they right?

Today, inflation remains low in much of the developed world. But previously dovish central banks in countries like the United States and the United Kingdom are itching to roll back the accommodative monetary policies that they have pursued since the eruption of the global financial crisis of 2008.

Inflation-targeting central banks assume that, when inflation expectations are stable, changes in inflation stem from changes in the amount of slack in the economy. When slack diminishes – as is happening now, with unemployment now well below average levels over the business cycle (and at multi-decade lows in the US and the UK) – inflation will eventually rise.

Already, these central banks have maintained loose monetary policies for much longer than in the past, in order to offset the headwinds to growth and inflation that the financial crisis produced. Yet they know from past asset bubbles that leaving monetary policy too loose for too long risks digging an ever deeper hole, with natural interest rates and potential growth ending up even lower in the next cycle.

So are investors in risky asset markets right to be so complacent? For now, there can be no definitive answer. But the record from past periods of calm suggests that, when cross-asset market volatility is low, de-risking is prudent.

To be sure, investors would have greater cause for concern if there were clearer signs of excessive risk-taking in financial markets and the real economy – the kind of excess that craves the monetary-policy punch. Because periods of asset-price euphoria – exemplified by the dotcom and real-estate bubbles of 2000-2008 – typically feature exceptionally loose monetary policy, central banks are now trying to extend the business cycle by removing monetary accommodation in a gradual and predictable manner.

But asset-price bubbles also tend to feature new innovations that entice markets and central banks into believing that this time really is different. In the post-crisis context, the most likely justification for higher asset-price valuations is the global decline in the “price” of savings (the natural rate of interest), or R-star. If corporate earnings grow as a function of trend growth (the underlying rate of growth), but funding costs remain a function of an even lower R-star, then equity multiples should be higher than in the past on a structural basis, and credit spreads should generally be tighter.

But, while this argument appears accurate today, investors have at least two reasons to be worried. First, to the extent that the gap between trend growth and natural rates drives up asset valuations, marginal changes in that gap should lead to changes in those valuations. If central banks were simply altering short-term interest rates – the traditional tool of monetary policy – as they have done in the past, this would be less of a concern.

But, in the present cycle, central banks have become far more dependent on indirect tools – namely, long-term interest rates. The effects of such tools are shaped by investor expectations, and are thus prone to sudden and extreme shifts. In 2013, for example, the US Federal Reserve’s suggestion that it would begin to taper off one of its quantitative easing programs triggered a “taper tantrum,” with money pouring out of the bond market and bond yields rising substantially.

The second key cause for concern is that higher valuations do not necessarily mean higher returns or better volatility-adjusted returns. Even if the positive gap between potential growth and natural interest rates justifies higher asset valuations, lower potential growth denotes lower returns across asset classes. As interest rates rise toward the natural rate, financial conditions should tighten, and risky asset valuations should fall. Central banks want this tightening to come about gradually, but the brief history of unconventional monetary policy suggests that asset re-pricing tends to occur abruptly – sometimes disruptively so.

Why, then, don’t investors take advantage of extremely low volatility to buy cheap insurance? Markets do not explode every time volatility is low, but volatility has always been extremely low when markets have exploded. Insurance is needed most when imbalances become extreme. Equity and credit valuations are not cheap; but they are not egregiously expensive, either.

Here on Earth, central bankers and bond investors have something in common: both worry that the current period of extremely low volatility is neither sustainable nor desirable. After all, lower combinations of fixed income, foreign exchange, and equity volatility have been seen three times before: just prior to the onset of the global financial crisis, in the month preceding the taper tantrum, and in the summer of 2014.

In short, there is no doubt that volatility will eventually rise to normal levels. For investors today, the lesson is clear: reducing the scale of risk exposure is the right way forward.