Welcome to Authers’ Note, in which I will attempt to provide some context and analysis on the world of investment each day, and provide you with a handy guide to the best coverage on offer, both here in the FT and elsewhere. All feedback is welcome, particularly of the constructive variety, as we try to get this right. (Email to email@example.com).
Some saw last week's volatility crash coming. The question is what happens next.
I will now quote at length from Tim Lee, an economist who runs pi Economics in Connecticut. He can certainly claim a lot of foresight. This is what Tim said in December in a piece on systemic leverage:
The bursting of this ‘pure bubble’ will represent a surge in the demand to hold dollar money, which will be indistinguishable from a collapse in the bubble in volatility selling — both being aspects of the same phenomenon. Other inevitable features of this will be a soaring dollar in the foreign exchange markets, a total collapse of volatility selling funds such as XIV, and of course a collapse of the prices of risk assets.
He had that one right (remember the dollar reversed direction and rose sharply while the rise in volatility was at its worst). Then last month, in his regular monthly bulletin, he said this:
I believe it is inevitable that XIV and similar funds will be wiped out in that process. Because XIV seeks to provide the inverse of the daily performance of VIX futures, a greater than doubling of short-term VIX futures in one day will put the net asset value of the ETN (and similar ETF/ETNs) negative. The problems that this will cause and the problems that other volatility selling strategies will face will trigger contagion across the financial markets. Liquidity will evaporate completely, the dollar — being the world’s funding currency — will soar and there will be a huge flight to the safety of US treasuries which will see the yield curve invert sharply.
He got what was about to happen to inverse Vix products exactly right, but so far the other pieces of the puzzle have not filled in as expected. The dollar has indeed risen, in a reversal of its preceding trend, but it is hard to say that it is "soaring". Bond yields shot downwards as volatility spiked on Monday last week, but since then their relationship to the stock market has been much more complicated. Whenever the stock market has staged any kind of a recovery, they have risen again. Now 10-year Treasury yields are testing a new level of resistance at about 2.9 per cent. The yield curve has steepened, and is further away from inverting.
Tim's take on this is fascinating. First, he argues that volatility in general, and the phenomenon of an artificially low Vix in particular, are central to the markets of the last nine years, rather than an interesting side-effect or symptom. As he puts it:
In the modern financial world, in which central banks globally are perceived to be underwriting markets — ‘the central bank put’ — the VIX becomes the closest thing there is to the price of money. Volatility selling uses leverage to provide liquidity to the markets. When the VIX was unnaturally low, as it was before last Monday, investors could insure long equity portfolios at very low cost, meaning they could benefit from equity market appreciation with very limited risk. This is equivalent to financial conditions being loose, which in the old days would have required the central bank to be implementing a loose monetary policy. As of now it is more expensive to insure financial risk so in a very real sense financial conditions have tightened — which fundamentally is equivalent to the price of money being higher.
That is an alarming prognosis. The follow-through effects would involve tightening credit and a rising dollar. This is not what happened during the last volatility shock, following the Chinese devaluation scare in 2015. But Tim points out that bond yields were lower then, and it turned out that there was an opportunity for volatility sellers to reappear and "buy the dip" once more.
I think it will be different this time. We are much further into the cycle of what might be thought of as underlying tightening of monetary conditions. The Fed is contracting its balance sheet and raising interest rates. On top of that . . . US imbalances are worsening with the personal savings rate set to fall to a new low while US government finances deteriorate further. Nominal and real bond yields are rising.
He does add that for a better outcome — "for me to be wrong" — bond yields have to level off, while the dollar has to stop rising. In both cases, this is what happened in 2015, and it is what has happened so far this week. This is a Bloomberg screenshot of what has happened to the dollar over the past month:
And this is the course of 10-year Treasury yields:
Now to find if this can be maintained. Bianco Research of Chicago published this chart to show that for the MOVE index of bond market volatility to stay this calm after a shock of this scale to the Vix index of equity market volatility is very unusual:
Red dots indicate unusually low MOVE reactions to extreme moves in Vix. Last Monday is marked — the only greater outlier, the furthest right of all the red dots, occurred on October 19, 1987, the day of the Black Monday crash.
In the aftermath of outliers like this, with low bond volatility and high stock market volatility, the stock market tends to put in a good recovery. But one critical reason for this may be that the Federal Reserve comes to the rescue. Bianco's research scoring "Fedspeak" by the central bank's governors for hawkishness and dovishness finds that the Fed has been more likely to respond to an equity drawdown by growing more dovish in recent years:
If this is true, then we again come back to fundamental questions. Is there really a pick-up in inflationary pressure? And if there is, would a stock market sell-off really be enough to dissuade the Fed from raising rates?
NFIB — No Problem
The NFIB survey of small business came out on Tuesday with a strong number, but not strong enough to scare the children. Small businesses remain optimistic.
One interesting chart suggests good news for Main Street, and for the Trump presidency, and potential bad news for Wall Street. Here it is:
Executives are given a laundry list of problems and asked which concerns them the most. The great news for the administration is that the two problems that perennially head the list have dropped. Neither taxes nor red tape any longer count as small businesses' greatest concern. That is just what policy has been aiming to achieve.
The bad news is that "quality of labour", which barely registered as an issue back at crisis time, is now their greatest bugaboo. They simply cannot find the staff, any more. This implies worrying things for the Phillips Curve. One argument for the ongoing lack of a trade-off between employment and wages has been that many are voluntarily not working. (This can be satirised as the "twentysomethings playing video games in their parents' basement" theory). Once conditions improve and there are more jobs, more of them will look for work, keeping a lid on wage rises. The alternative argument is that there is a group of people who have been unemployed for a long time and are now unemployable. This implies that "underemployment" is not as severe as it seems, because many of those shown in the statistics as not seeking work would indeed be incapable of holding down a job. They lack the skills and they have been left behind. This latter theory implies a human tragedy. It also implies that the labour market is tighter than it looks, and the supply of qualified workers is limited — meaning that there is a risk of inflationary wage rises as the economy improves.
Sadly, this latest data point from the NFIB is in line with the "human tragedy" explanation.
Are you better off than you were a year ago?
This, more or less, was the question Ronald Reagan used to beat Jimmy Carter for the US presidency in 1980. He ended up winning very comfortably after what had been a closely fought campaign, after persuading voters in his debate with the president to ask if they were really better off than they had been four years ago. For many the answer was "no", and Jimmy Carter was voted out of a job.
Reagan was in line with political orthodoxy among political scientists, that a large part of the return in elections can be explained by "retrospective economic evaluation". If you think the economy has done well since the last election, you vote for the incumbent. If not, you vote for the challenger.
The problem is that the political environment in the US has grown so charged — and I do not doubt that a similar phenomenon is at work in continental Europe and the UK — that political assessments give rise to economic assessments, rather than the other way around. This chart, adapted by Peter Atwater of Financial Insyghts from Gallup's regular polling, shows economic confidence by party affiliation:
Republicans were more confidence under George W Bush, and then Democrats were more confident under Barack Obama, but the dramatic shift in confidence in the past 12 months is very impressive.
The following map shows what states are above or below average in economic confidence. The darker the state, the greater the economic confidence:
Voters in a great swath of "red states" in the centre of the country and in the south are more confident than they were a year ago. People on the west coast and in the northeast are less so. This map, which shows the states feeling more confident and where Trump won, almost perfectly matches the political map of the US:
The standard assumption was that economic confidence would lead to a political evaluation. This time around, a political outlook seems to have led to an economic outlook. The direction of causation has turned around, as political identity now appears to swamp our sense of economic wellbeing, for those on both the political left and right. To quote Peter Atwater:
The charts above — not to mention President Trump’s approval ratings during his first year in office — suggest that, at least for now, that correlation is broken. Our political identity is driving both our view of the President as well as our view of the economy. Our perception of our political strength is an overriding factor.
How the left and right navigate this change in correlation in the midterm elections will be very interesting. Looking ahead, short of a major meltdown, for political candidates, this time it won’t be the economy, stupid."
One consequence for market watchers is that we need to be more careful with soft data than before. If economic assessments spring from people's political assessments, they may not be as useful to us. Small business owners taking part in the NFIB survey tend not to be bleeding heart liberals. So bear this in mind when reading these quotes from the heads of the NFIB: