Is rising volatility a sign of doubt about economic recovery?
Tue, Jul 21 2009, 08:15 GMT
by Trevor Williams
After a run of monthly economic indicators suggesting that the worst of the economic downturn has past, and some stabilisation and improvement in financial markets (accompanied by big profit announcements by some investment banks for Q2), some commentators believe that recovery is all but assured. Unfortunately, the reality may be rather more complicated, as economic and market indicators are not showing recovery but a deceleration in the pace of economic contraction. One way of assessing this perception is to look at volatility in a range of financial and market indicators. If risk perceptions rise, one would expect volatility to rise, but if risk perceptions fall, then volatility would be expected to fall as well.
Market volatility is rising again…
From March 2007, volatility in stock markets, as measured by the VIX (30 day annualised implied volatility of the S&P 500), rose from around 10 to a peak of around 80 in November 2008, indicating a risk that the market value of the S&P 500 could drop by 80%. Since the collapse of Lehman Brothers in September, however, the index has fallen back rapidly, recently reaching the mid 20s. However, it has risen in the last few weeks, as doubts about whether the global financial and economic crisis has ended have increased. Another key measure of riskiness, and volatility, this time in credit markets, is the Itraxx, which tracks the cost of buying insurance against bond default. This has moved with the VIX, see chart a, rising sharply immediately after Lehman Brothers’ collapse but falling back following the unprecedented action by central banks and governments around the world to inject liquidity into financial markets. Currency volatility has improved but remains high, much higher than would imply stability or significantly reduced risk, as shown in chart b, which measures the one month implied and historical volatility of dollar-based currency options. There is also significant term interest rate volatility, see chart c, which has shown a rise recently.
…but why is this?
Long term bond yields, which had risen quite sharply recently, accompanied by a steeping of yield curves, a sign of rising inflation pressure or at least of faster economic growth, are now pointing lower. A month ago, the US 10-year Treasury note rate reached 4%, it is now 3.7%. In the same period, the UK 30-year gilt yield hit 4.8%, the highest level since January; it is now at 4.5%. In terms of swap rates, the UK 2-year rate touched 2.57% in mid June and the 5-year rate 3.80%.Overall, we estimate that yields are down by about 25 to 75 basis points in this period. Looking at inflation expectations, however, shows that they remain fairly stable. Inflation expectations, measured by the US Michigan survey and the UK financial market-based breakeven rate, remain benign, see chart d. Looking ahead, and using the latest Lloyds TSB six-monthly Business in Britain Survey, shows that spare capacity in UK industry, see chart e, will continue to bear down on inflation in the year ahead. This means that the reason for the rise and latest fall in yields is down to expectations about economic growth, and not about expectations of inflation.
Economic recovery remains beset by fundamental concerns
Sustainable economic recovery will partly depend on an unwinding of a range of imbalances. One is in asset prices, of property and equities and securitised instruments. The uncomfortable fact may be that though equities are well down, and might be at or close to ‘fair’ value, there could still be sharp falls if the economic outlook worsens relative to current earnings expectations. Also, for similar reasons, there have to be doubts about the prices of property and securitised assets. For instance, real estate prices became very high relative to incomes during the boom years. Although they have since fallen back, recovery will depend on them having fallen back enough to induce a perception that they are so cheap that they cannot fall any further and the next move is up. The same applies to commercial real estate. Have they dropped back far enough, or do they have further to fall? The answer is not clear, though there are signs that residential and commercial property prices are nearing some trough, it is not yet clear that they are cheap.
There are also some key economic imbalances that lie behind these financial market-based anomalies. Many of the developed economies exhibit high levels of current account deficits, a result of low domestic savings and high borrowing from overseas. Take New Zealand, for instance, Fitch recently reiterated New Zealand’s AA+ sovereign credit rating, but downgraded its outlook from stable to negative. The reason is its external vulnerability stemming from the size of New Zealand’s current account deficit, which at 8.5% of GDP is clearly unsustainable in the medium term and needs to be addressed to prevent a sharp depreciation of the New Zealand dollar in the future. But the same applies to the UK, US, Spain and a number of other economies, to a greater or lesser extent. In short, domestic savings rates are still too low, spending too high and currencies possibly too strong.
This implies that there might be another bout of deleveraging and unwinding of the global credit bubble before sustainable economic recovery in the developed economies can really begin. Of course, it may be that the infusion of public sector liquidity has postponed this outcome, or that it might be that these economies can get away with a weak recovery, spread over time, rather than experience another crisis this year. The improvement in the economic data that has been seen is the result of severe cuts to inventory levels. The test of whether economic recovery is sustainable will come when the bounce from this wears off and final demand, of consumers and companies for investment, materialises or not. Unfortunately, this may not be clear until well into the second half of this year.
