The following is another extract from my half year outlook, completed 23rd June.
As we head into the half year end, the lack of volatility in markets is one of the defining factors for pretty much all asset classes. For FX, we’ve seen declines in both intra-day ranges and by design implied volatility in the options market. At the same time, bonds have rallied, both in the US (on the back of the weaker economy) and also peripheral Europe. Italian yields were on a par with UK yields mid-June. Even short-dated German government paper is at a real risk of seeing negative yields once again (as happened in 2012 and the first half of 2013).
The reasons are plentiful, not least the lack of policy action from central banks, together with the reduced effectiveness of current policies that have been running (on and off) for several years now. Furthermore, forward guidance has meant that markets have placed a lot of faith in central banks and put little risk of them actually being incorrect in their ability to keep rates low for an extended period.
The parallels with 2007-08 have already been made, but are pertinent. Back then, there was an over-reliance on the ability of central banks to deliver non-inflationary growth and the financial system to adequately price and diversify risk. The fact that the latter two assumptions proved to be incorrect, primarily in relation to sub-prime mortgages in the US, but also elsewhere (e.g. peripheral yields in Europe), was one of the primary catalysts of the global crisis that followed. This is not to say that we are heading for a similar scenario now, but the under-pricing of risk in general, and the stretched valuations on assets, should not be ignored.
There are two potential catalysts to greater volatility. The first is that there is a rush for the exits, combined with lower liquidity, that arises from the current valuation of equities and other asset markets. The second is greater action, or potential action from central banks, together with less guidance from them on the likely future direction of policy. We are potentially seeing this shift in the UK (more on this below), which has already been felt on sterling, both in term of actual volatility and also options pricing, with premiums rising as a result. Before Carney spoke in June, suggesting that the market was under-estimating the chance of a rate hike this year, I was of the view that the Bank’s stance was becomingly increasingly flawed in trying to guide the market (see “Killing Forward Guidance” from May).