Last week we concluded that risk assets are less risky when volatility is high. This raised a few questions, and I thank you for passing them on to me.
The problem is indeed complex. We distinguish two main categories of volatility spikes. The first type, which is of technical nature, is due to the disorderly liquidation of crowded leveraged positions, generally following a long period of very low volatility. Modern financial markets are particularly prone to such dislocations. Consider that in normal times, high-frequency traders are the main suppliers of liquidity to the market. However, unlike the good old market makers, those traders withdraw instantly when there is turbulence, such as during flash crashes.
The second type of volatility is motivated by a fundamental degradation of the economic environment. Credit spreads then deviate in conjunction with an increase in volatility. As long as the causes of the cyclical deterioration are not addressed, high and increasing volatility is not a good omen.
On average I sleep better when investors pay a lot to insure themselves against risks that make news headlines than when the VIX volatility index stays permanently below 10%.
The problem is exacerbated by what George Soros calls ‘reflexivity’. A technical dislocation that leads to market turbulence can itself affect the real economy through increasing risk aversion and the negative wealth effect in today’s highly financialised economies. The problem is complex, as I say, but on average I sleep better when investors pay a lot to insure themselves against risks that make news headlines than when the VIX volatility index stays permanently below 10%.
The federal reserve aims at reaching a desired price index level
As expected, Jerome Powell used the Jackson Hole platform to announce the outcome of the strategic review of US monetary policy launched in 2018. A change in the US Federal Reserve’s (Fed) approach has local and global implications due to the US dollar’s status as a global reserve currency. The Fed used to operate with a double mandate: slightly positive inflation at around 2% on the one hand, and full employment on the other. Since the 2008 recession, the Fed has systematically missed its target for price increases. For instance, if inflation had reached 2% annually since 2008, the price index level in the United States would have been more than 5% higher than it is now (see chart of the week). Fed Chairman Powell therefore announced that from now on, the Fed will allow inflation to slightly exceed the target level of 2% if this level has not previously been reached. In a way, the target is no longer 12-month rolling inflation but the level of the price index. We are one step further into MMT (Modern Monetary Theory).
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