1. From a volatility bubble to a complacency bubble and back

From a volatility bubble to a complacency bubble and back

Summer lull continues in financial markets. August is turning out to be a quietest month on record, with realised volatility across asset classes and EM currencies falling to multi-year and even multi-decade lows.

By: | New Delhi | Updated: August 28, 2016 2:42 PM
Global economy lacks other major supporting planks due to weakness in emerging market lead by China. (Reuters)

Global economy lacks other major supporting planks due to weakness in emerging market lead by China. (Reuters)

Summer lull continues in financial markets. August is turning out to be a quietest month on record, with realised volatility across asset classes and EM currencies falling to multi-year and even multi-decade lows. Take the case of Dollar Rupee, the monthly volatility is at 0.5%, lowest since January 2007. Historically, the period between August to October has been a highly volatile period for Dollar/Rupee pair but this year actual prices are way off the historical pattern. However, there a few reasons why we expect volatility to pick up in months ahead. For one, the tilt of US Fed towards monetary policy divergence is positive for volatility. Secondly, the transition in India’s monetary policy structure away from a governor towards a committee with an inflation target will also aid volatility. Finally, scheduled global events like Italy’s constitutional referendum and US Presidential elections would also be a volatility spinner.

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There has been a sharp rise in hawkish rhetoric from US Fed over the past few weeks. The first day of speeches from Jackson Hole symposium, saw a number of Fed officials, including Fed Chair and vice Chair opening the door for a September hike in US policy rates as well hint for another move in December. US money market was not pricing any hike this year and hence was taken by surprise. As a result, market based rates or yields hardened and US Dollar strengthened on the news. However, we were not surprised by the turn of events as we had expected the same based on the following line of arguments:

US Fed possibly believes that the ongoing up cycle in financial asset prices and credit markets are joined at the hip. Therefore, a major downturn in one can affect the other, triggering a vicious loop which can suck the economy down the vortex. Global economy lacks other major supporting planks due to weakness in emerging market lead by China. However, a weak economy, falling corporate profits, weak private investments and still fragile global consumer leverage cycle, stock prices and credit markets could be becoming frothy. Fed is riding a tiger. Hence, if they are not over careful, the tiger can eat them and the economy and their credibility can slide down the barrel. Therefore, Fed needs to ensure that frothy financial markets do not get uncontrollably complacent so normal doses of shocks need to be administered from time to time. Over the past six months there has been a 180 degree shift in global volatility regime, from paranoia to extreme complacency. A major anchor on which the shift occurred was monetary policy path, a move away from divergence towards convergence. Fed would no longer talk hawkish and let other central bankers, who are all on the dovish boat to steer global asset prices higher. Having achieved asset price surge, it is time now to moderately shock financial markets out of their complacency but talking once again about monetary policy divergence. Monetary policy divergence whips the dollar higher and puts strain on China. A combination of stronger US Dollar and unstable China knocks down commodities and EM asset prices. A deflationary regime is unleashed. However, make no mistake, US Fed would once again look to short circuit the purge, when it would threaten to get out of control, by flipping back to monetary policy dovishness. We understand it is a dangerous game which Fed is playing and the question if not if, but when, it gets out of their control, the effect on global economy, financial markets and financial system could be significantly adverse.

Economic cycles have been shallow and short since the beginning of the global economic rebalancing in 2007. The short and shallow cycles have been a major drag on Fed’s ability to forecast economic trends and hence decide on a glide path of monetary policy. In fact, a much of skill that they thought they possessed after a great long prosperous period of 1980-2007, was more good luck. The analogy which we can use to understand this would be like flying a plane. For a much of the 27 year period, US economy was like flying a modern airliner on an auto pilot through stable weather conditions. Post 2007, not only the auto pilot has died but weather conditions have become treacherous. Quite a shock for a pilot, who was so used to them and believed that it is his great skill, which made the journey so smooth and on time. Therefore, post 2007, US Fed has been forced to flip flop on its economic forecast and monetary too much to their own liking. Credibility has suffered. In fact the numerous inflexion points on Fed’s hawkish and dovish steer has coincided with the twists and turns of the S&P500 indices. It is as if equity markets have front run US Fed. A too complacent bull has become the harbinger of Fed’s hawkish wrath and a paranoid bear has brought the good omen of the fairy god mother.

The next US Fed policy is still a couple of weeks away and between then and now we expect financial markets to parse each and every economic data out of US. Every better than expected data on jobs, wages, housing and consumer spending will be cheered by US dollar as odds of rate hike will pulsate with economic trends. The odds for a hike by September stands at 33%, higher from 21% on last Thursday but for December it has jumped to nearly 60%. In case the incoming economic data maintain a robust uptrend then we can see September hike probability jump towards 50% and December cross the threshold of 70%, a level which has sealed the rate hike in past. We still believe one and two hike in possible this year, but remember all that matters in how committed is Fed towards monetary policy divergence over convergence. Keep an eye on China, as the economy is sliding downhill rapidly and the opaque financial system is threatening to crunch the economy harder. We have been bearish on Chinese Yuan for over 2 years now and continue to be so. A divergent Fed will only accelerate the pain for China.

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Coming financial assets, we see scope for Rupee depreciation, a move towards 67.80/68.00 remains on cards. We see little scope for appreciation beyond 66.70 levels over the medium term, as RBI continues with its interventionist policy in forex market. However, Rupee to gain further against GBP and Yen over the near term and stay ranged against Euro. Indian 10 year yields may stay within a range of 7.10/7.16% over the near term.

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