VIX and Monetary Policy
I have discussed in the past using the VIX as a hedge for equity portfolios. In the past few weeks, I have received quite a few inquires about why the VIX is so low given all the macro issues facing the global economy. As a primer, remember that the VIX measures the cost of buying 30 days options on the top 100 U.S. stocks. When the level is low it is believed that investors are too complacent.
Many commentators believe that the US equity market (like housing) is being artificially propped up by the Federal Reserve's policy actions. Mr. Bernanke's trump card, QE3, was kept in reserve until last week allowing market participants to remain complacent - the so called Fed "free put". Why pay for protection when Ben has your back? However, if one looks at longer dated volatility (for example go out 1 year versus the standard one month) and long term volatility measures are not nearly as low. So it would appear, as FT's James Mackintosh notes, that the "free put" is really just short term in nature. Now that the FED has introduced QEternity, my guess is that the VIX has bottomed and the entire volatility curve is likely to shift upwards. Monetary policy has now officially run its course and in fact could potentially be damaging to the economy. The market will fade this QE more quickly than the last two as the real changes required for the economy to grow and create the jobs the FED is now looking for, require structural reforms.
Why is Monetary Policy Now Damaging?
It seems like we have been living with QE for forever. People forget that this “tool” is both new and unproven – it is non-traditional; it is experimental: As Jim Grant aptly describes it “For Policy A, you bet your boots on outcome B but while Policy A may deliver outcome B, it may alternatively serve up outcomes J or Q or Z – or, not inconceivably, some other result too strange to be classified”.¹ In other words, the probability of unintended consequences is high – and this adds to the appeal of reasonably priced VIX futures now.
But what are the unintended consequences? Maybe the Fed, seeing a real change for the worse has decided that, like chemotherapy for cancer patients, side effects be damned. Or worse, the US economy is like a Phase 1 clinical trial – fingers crossed. William White submitted an excellent Working Paper in August to the Federal Reserve Bank of Dallas.² He stated that ultra easy monetary policy may serve up undesirably long run effects.
“The conclusion is that there are limits to what central banks can do. One reason for believing this is that monetary stimulus, operating through traditional (“flow”) channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative (“stock”) effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the “independence” of central banks, and can encourage imprudent behaviour on the part of governments”.
For me, the moral hazard created by ZIRP for governments is extreme. Despite the massive rise in government debt outstanding, the yearly interest bill has continued to fall – delaying and in fact likely lulling government officials into a very false sense of security. Worse, as Leigh Skene of LSR suggests;³
“Excessively low interest rates benefit those close to the money printing process, such as bankers and wealthy speculators at the cost of the non-financial companies and workers who produce the wealth, but exist far away from the money printing process. This is increasing income inequality and hands political power to those who are redistributing wealth from the poor to the rich, such as to-big-to-fail bankers. This is the exact reverse of the trickle-down effect of wealth that proponents of monetary stimulation claim, which assumes lower interest rates stimulate spending”.
There is evidence mounting that CEO’s of those non-financial companies are increasingly alarmed with the lack of progress on the “fiscal cliff”. For some it is an excuse but for many it is a real concern. They now understand the negative feedback loop associated with poor government and monetary policy. They have good reason to hold such large cash balances despite the cries of central bankers like Mr. Carney. Ask the CEO’s of insurance companies and those managing money market funds how well the FED is doing for their businesses. There is no doubt that the FED has slowed the pace of decline especially with the first QE. They bought time for governments to act but as we all know politicians will only act when the market riots.
Finally, there has to be concern that all this monetary policy has made a mockery of true market pricing (although one would have to add in the HFT thugs to this mix as well). All in all, the VIX looks like a good and unintended beneficiary of central bank policy.
- Grant’s Interest Rate Observer, September 7, 2012 – page 1
- Ultra Easy Monetary Policy and the Law of Unintended Consequences, William R. White, August 2012, Federal Reserve Bank of Dallas, Working Paper No. 126
- Seven Unintended Consequences – but who’s counting? Lombard Street Research, Leigh Skene, September 16, 2012.