TWN Info Service on Finance and Development (Mar18/01)
15 March 2018
Third World Network

Volatility is back in markets, says BIS
Published in SUNS #8640 dated 13 March 2018

Geneva, 12 Mar (Kanaga Raja) - Stock markets worldwide underwent a sharp correction in late January and early February, with the release of a labour market report showing higher than expected wage growth in the United States heralding a burst of heightened activity, the Bank for International Settlements (BIS) has said.

In its latest Quarterly Review released on 11 March, highlighting developments in international banking and financial markets, BIS said equity valuations fell, rebounded and fell again, amid unusual levels of intra-day volatility. This correction coincided with higher volatility in government bond markets.

According to the Basel-based central bank for the world's central banks, the market tremors occurred within a general context of protracted US dollar weakness for most of the period, continued loosening of credit conditions, and undaunted risk-taking in most asset classes.

BIS noted that a brief flight-to-safety event associated with the peak of the stock market turbulence provided only limited support for the dollar.

Neither the Fed's steady tightening nor the recent equity sell-off coincided with wider corporate credit spreads, which remained at record lows, it said.

"The appetite for emerging market economy (EME) assets also stayed strong. Stock markets soon stabilised and trimmed their losses."

At the same time, said BIS, bond investors appeared to struggle in assessing the overall impact of an evolving inflationary outlook and the uncertain size of the future net supply of securities with longer tenors.

BIS also noted that throughout the period under review, which started in late November, market participants remained very sensitive to any perceived changes in central banks' messages.


In some written on-the-record remarks released with the Quarterly Review, Mr Claudio Borio, Head of the BIS Monetary & Economic Department, said: "Volatility is back. Not across the range of asset classes: it has largely been confined to equities, with just a few ripples in sovereign bonds and exchange rates."

"And we do not know how long it will stay. But it is back, and some volatility is healthy. There are few things more insidious in markets than the illusion of permanent calm. As experience indicates, that illusion can set the stage for some of the largest and most damaging losses."

According to Mr Borio, the period under review started to unfold along the same lines as the previous one, which itself traced a pattern that had been in place for some time.

"We saw an entrenched risk-on phase, with equity prices flirting with new headline highs, volatility at or close to multi-decade lows across asset classes, credit spreads unusually compressed, and strong portfolio flows to emerging market economies (EMEs)."

In addition, a depreciating US dollar eased conditions further for the many private and public sector dollar borrowers worldwide, especially in EMEs.

As a backdrop, there were signs that global growth was strengthening and broadening further even as inflationary pressures remained subdued - what market participants had dubbed the "Goldilocks" economy, said Mr Borio.

"Then, like a bolt from the blue, after a very shallow slide, on 2 February the US stock market went into a tailspin amid a surge in volatility, more than erasing the sizeable gains accumulated since the beginning of the year."

As is often the case in such episodes, the market recouped part of the losses in the following days. Subsequently, it did not change that much, hovering at levels close to those prevailing in December, until trade tensions led to further market jitters at the beginning of March, after the Quarterly Review went to print, he said.

Other stock markets have followed a similar pattern, although losses in Japan have been somewhat larger and longer-lasting.

As to what explains "such a sudden and disorderly drop in the US stock market", Mr Borio answered that bond yields had been drifting up for some time before the plunge - a key development during the period under review that extended a slow trend in place since the trough in September last year.

And in the previous week they had proved quite sensitive to a Treasury announcement of large issuance across the maturity spectrum, which appeared to take market participants by surprise.

"But this had hardly affected equities. The trigger for the drop appeared to be the release of a strong wage growth figure in the United States, taken as pointing to the risk of an unexpected increase in inflationary pressures. The yield on Treasuries rose, and equities started to dive."

Soon afterwards, on 5 February, internal market dynamics took over, in a way reminiscent of the 1987 stock market crash.

Back then, the protagonists had been automated trading strategies called programme trading and portfolio insurance.

On this occasion, said Mr Borio, it was the turn of the likes of exchange-traded products (ETPs), Commodity Trading Advisors (CTAs) and, seemingly to a lesser extent, risk parity strategies.

What these investment vehicles, players and trading algorithms have in common is that they either take positions in volatility directly or, like CTAs, were wrong-footed and forced to sell in order to cover losses.

As on previous occasions, leverage, be it overt or embedded in the various instruments, amplified the moves. Unlike on those occasions, volatility products now enabled participants to trade volatility directly.

Hence the outsize spike in the VIX: while it is well known that volatility increases as the market plunges, the increase this time was way out of proportion to the equity market drop.

"Where does all this leave us," Mr Borio asked.


In this regard, Mr Borio highlighted a number of observations.

"First, the market wobble has not fundamentally changed the overall economic and financial picture. Financial conditions remain unusually accommodative. Credit markets have hardly budged: credit spreads have continued to tighten to multi-decade lows; and there are indications that other credit terms, such as covenants and the like, have ignored the market spasm," he said.

What's more, in the background, the US dollar, after a persistent depreciation, has continued to stay weak - a tell-tale sign of easing financial conditions, especially for EMEs.

The dollar's depreciation has been surprising, given the combination of tighter monetary policy and fiscal expansion, for some reminiscent of the constellation of the early 1980s, when the dollar appreciated strongly.

That said, it is not unprecedented. The dollar actually depreciated in the 1990s and 2000s, when the Federal Reserve made progress with its tightening cycle; and in the 2000s this also went hand in hand with a fiscal expansion.

Possible explanations for the current depreciation include the very gradual and telegraphed tightening pace, the strengthening global recovery outside the United States, concerns over the unsustainability of the fiscal position, and statements in January by high-ranking officials understood to be aimed at "talking down the currency".

Still, the truth is that it is very hard to tell. As the American satirist and cultural critic H L Mencken once said: "Explanations exist; they have existed for all time; there is always a well-known solution to every human problem - neat, plausible, and wrong."

This could equally well apply to the rationalisation after the fact of surprising currency moves, said Mr Borio.

Second, the market wobble may well not be the last. Financial markets and the global economy are sailing in uncharted waters.

And after an unusually long period of unusually low interest rates and accommodating monetary conditions, it would be unrealistic to expect no further market ructions.

"What we saw this quarter is simply the latest reminder of how such a period complicates exit, by inducing market participants' risk- and position-taking."

In addition, it has highlighted just how much prevailing market trends depend on a benign inflation outlook. No doubt, the wobble has shaken off some positions - the equivalent of pressing a "reset" button. But the overall picture has not fundamentally changed, said Mr Borio.

"Finally, all this underscores how delicate a task central banks are facing. They need to strike a balance between normalising policy, not least to increase their room for manoeuvre to deal with the next downturn, on the one hand, and avoiding unnecessarily derailing the expansion, on the other."

And they need to do so in a world that, post-crisis, has witnessed a further increase in overall debt in relation to incomes and output. The path is a narrow one. And it requires the active support of other policies.

"The most recent protectionist rhetoric complicates matters further," Mr Borio said.

"Treading the path will call for a great deal of skill, judgment and, yes, also a measure of good fortune. But policymakers need not fear volatility as such. Along the normalisation path, some volatility can be their friend," he said.

Also in some on-the-record remarks, Hyun Song Shin, Economic Advisor & Head of Research at BIS, referred to the remarks by Mr Borio on the recent financial market developments and said fast-paced movements in financial markets hit the headlines, but slow movements in the background can matter more for the economy.

"Their importance becomes apparent only after some time," Mr Shin added.


According to the BIS Quarterly Review, equity prices rallied globally after the seasonal Christmas lull.

During the first few weeks of January, the S&P 500 rose more than 6%, in one of the strongest starts to the year since the late 1990s.

In those weeks, the Nikkei 225 jumped 4%, EME stock markets rose almost 10% and European stocks went up more than 3%.

At the end of the month, the rosy picture changed abruptly. On 2 February, a stronger than expected US labour market report - stating that non-farm payrolls had risen 200,000 in January, while wages had increased 2.9% year on year - seemed to stoke concerns of market participants about a firming inflationary outlook.

The payroll figures were above analysts' expectations, and were accompanied by news that job creation during 2017 had been revised upwards.

But it was the large annualised increase in hourly earnings that received the most press coverage, being the highest rise in wages since the end of the recession in mid-2009.

The figure was widely perceived as increasing the chances of a faster pace of monetary policy tightening by the Federal Reserve.

Global stock markets fell sharply in the wake of the report. During the week following its release, stock indices gave away the year's gains, and more, with the S&P 500 falling by further than 10%, the Nikkei by 7%, EME stock markets 8% and euro area stock markets 7%.

There were indications that forced sales by commodity trading advisers and other momentum traders, in response to accumulated losses on their cross-asset positions, had helped amplify initial short-term market movements.

Stock markets stabilised subsequently, and added moderate gains up to the end of February.

BIS said the declines in stock markets were accompanied - and possibly exacerbated - by a spike in volatility.

Equity and exchange rate volatility - both realised and implied - had been falling for a while and had touched new all-time lows early in the new year.

When the market indices started turning down, stock market implied volatilities skyrocketed, especially for the S&P 500, approaching levels last seen in August 2015, when markets were roiled by changes to China's foreign exchange policy.

Implied volatilities in bond and foreign exchange markets jumped too, though staying within range of their post- Great Financial Crisis (GFC) averages.

"Volatility dynamics appear to have been accentuated intra-day by trading patterns related to rapid adjustments in positions in complex financial products that had been used to bet on persistent low market volatility," said BIS.

A sharp increase in long-term US bond yields heralded the stock market stress. Bond yields, which had steadily increased by about 35 basis points from mid-December, rose sharply over the first two days of February.

Prior to the surprising strength of the US labour market report on 2 February, which boosted 10-year yields by about 5 basis points, bond investors had already been rattled by the US Treasury's quarterly refunding plan, released on the morning of 31 January.

The plan featured unexpected, albeit modest, increases in the auction size of all coupon-bearing nominal securities, including the benchmark 10- and 30-year bonds.

The rise in long-term yields steepened the US term structure, which had been flattening for most of last year.

Short-term yields had been increasing from early September 2017, as the beginning of the Federal Reserve's balance sheet reduction process appeared imminent.

Meanwhile, long-term yields significantly trailed the shorter tenors, staying essentially flat until last December.

"The subsequent boost to longer yields coincided with the approval by the US Congress of a major tax reform package, which was seen as likely to spur a significant fiscal expansion," said the BIS report.

A firming inflationary outlook was at the root of the increase in US long-term yields during the period under review.

US inflation stayed low in the backward-looking monthly figures, and survey-based measures of inflation expectations remained stable.

But a stronger than expected CPI reading in mid-February highlighted market participants' nervousness about upward inflation risks, as the news was followed by yet another bout of yield increases and stock market softness.

According to the BIS Quarterly Review, market-based measures of inflation compensation have increased materially since mid-December.

The 10-year break-even rate derived from US Treasury Inflation-Protected Securities (TIPS) crossed the 2% threshold soon after the turn of the year, and continued rising.

Other gauges followed comparable paths. The market-based inflation compensation measures decreased in the wake of the market turbulence.

The expected path of future interest rates has also steepened substantially in recent months. In consonance with the gradual expected path of monetary policy tightening, the estimated expected future rate component of the 10-year zero coupon yield increased steadily from early September.

Similar developments across the maturity spectrum underlay increases in the shorter tenors of US Treasury securities.

"The recent rise in long TIPS rates themselves (which should reflect real yields) may point towards the contribution of rising term premia to higher long-term nominal yields, in particular after the market turmoil."

The 10-year TIPS yield had been slow to react to the Fed's balance sheet normalisation announcement in September, closing its spread over the five-year TIPS.

But after this spread stabilised in December, it rose again in the wake of the market moves of early February.

In other words, said BIS, a sudden and persistent decompression of the term premium at the beginning of February, while inflation break-evens stabilised, pushed nominal and real yields higher.

This suggests that inflation expectations largely drove yields until late January, with the term premium the driver of yields thereafter.

The timing of the term premium decompression, following the release of the quarterly re-funding plan, suggests that investors' reckoning of its implications for the future net supply of long-term securities may have played a role.

In the short run, however, the large short position recently built by speculative investors may give way to additional volatility and occasional falls in long-term benchmarks in the event of "short squeezes".

Government bond yields also increased elsewhere, but mostly in the longer tenors.

The synchronised strengthening of the global economy was seen as supportive of higher rates, especially at the long end, as investors seemed to anticipate a quicker exit from unconventional policies.

"Despite equity market turbulence and higher yields, financial conditions remained very accommodative in the United States, with minimal signs of overall stress. In fact, global credit markets were largely unfazed by these events," said BIS.

The financial outlook remained strong in emerging market economies as well. The strong performance of EME bond markets was underpinned by steady capital inflows, which reached a multi-year record high in January, after continued positive net inflows throughout 2017.

Inflows to EME equity funds were more contained in February, whereas bond funds faced small redemptions.

There were no indications that appetite for EME debt and lending to other less established borrowers has waned.

BIS also said that oil and other commodity prices saw some volatility during the equity market wobble, possibly because of de-risking by commodity trading advisers that exacerbated intra-day movements.

But all commodity indices ended with net gains by the end of the period.


According to the BIS report, the stock and bond market developments took place against the broad backdrop of US dollar weakness.

The dollar had been depreciating against most currencies since the beginning of 2017. The slide had been briefly arrested by last September's announcement of the start of the Federal Reserve's balance sheet run-off, but it resumed in December.

The stock market correction interrupted it only briefly, in part because of the short-lived flight to safety that followed.

By the end of February, the currency was down 1% from the beginning of the year, as measured by the broad trade-weighted index.

BIS noted that the persistent weakness of the dollar is, in many respects, hard to reconcile with developments in monetary policy.

It said gradualism and predictability notwithstanding, the Federal Reserve has been steadily tightening its stance since December 2016.

The central bank again raised the fed funds target range by 25 basis points in December 2017, and the future path of policy rates, as depicted by the "dot plot" of forecasts by members of the Federal Open Market Committee, stayed mostly unchanged.

In contrast, the European Central Bank (ECB) did not set a termination date for its asset purchase programme (APP), and expected its key policy rates to remain unchanged long past the programme's horizon.

The Bank of Japan signalled that qualitative and quantitative easing would continue.

As a result, spreads between future expected short-term rates in the United States, on one side, and the euro area and Japan, on the other, continued to widen.

"That said, dollar weakness during a period of Fed policy tightening is not unusual," said BIS.

It noted that the dollar had also depreciated during the Federal Reserve's two previous tightening cycles in 1994 and 2004.

In the course of the first 15 months of the current cycle, the dollar has depreciated by 11% against other AE currencies, as measured by the DXY dollar index.

Over a similar time span, the dollar had depreciated by about 14% during the relatively stronger 1994 tightening, and by only 1% during the more gradual 2004 episode, in each case as indicated by changes in the DXY index.

However, the dollar had indeed appreciated, albeit moderately (3%), during the comparable window of the 1979 tightening. Both in 1979 and 1994, the bulk of the dollar appreciation occurred after the tightening cycle had finished.

"The position of the dollar at the beginning of the tightening vis-a-vis its long-term average value does not explain these exchange rate moves. Market commentary has emphasised that the relatively strong initial position of the dollar at the beginning of the current tightening cycle was a factor explaining its subsequent weakness."

But the finding does not carry over to the other events. Both in 2004 (when the depreciation was small) and in 1979 (when the appreciation was moderate), the currency had entered the policy tightening episode 8-10% below its long-term average.

In contrast, a dollar that was slightly below its mean in 1994 went on to depreciate almost 15% in the following months.

Similarly, market observers' emphasis on the role of the "twin deficits" (fiscal and external) is not clearly borne out by the data.

True, the current account was slightly positive in 1979 (when the dollar appreciated) and negative in the other three events (when the dollar depreciated).

But the external deficit in 2004 was more than double the one observed during 1994 and 2016, and yet the dollar depreciated much less in 2004.

On the fiscal side, the average deficit-to-GDP ratio was roughly similar in the first three episodes, and higher in the current one.

But fiscal consolidation was actually on the march in 1994, when the dollar depreciated most, while fiscal deficits were expected to increase during the other episodes because of significant tax cuts.

BIS said that while it is hard to find a clear link between the external deficits and the exchange rate in the data, protectionist rhetoric in the United States may have indeed played a role in the dollar's recent weakness, as well as statements by high-ranking officials that were understood to be aimed towards "talking down the currency".

The dollar's depreciation has not been uniform across all currencies. In particular, the euro has proved especially strong. Since December 2016, the euro has appreciated by about 14% against the dollar.

In contrast, during the same time span the yen has appreciated by 6% and other currencies by just under 6%.

As the euro area economy continued to strengthen throughout last year, investors were increasingly pricing in a sooner than previously expected end to unconventional monetary policies, adding support for the currency, said BIS.