Reflections on Volatility by Mr. Practical
Fed Targets Volatility
Portfolio managers and almost all investors alike associate increased volatility with losses. If you chart “volatility” against the prices of all major asset classes, you find a significant negative correlation: high volatility is almost always accompanied by lower asset prices. The Federal Reserve knows this; that is why they have as a stated objective “low volatility”. High asset prices make the Fed’s job a lot easier, whatever that job really is (maybe it’s really to keep asset prices high; more on why that may be later).
Changes in Liquidity
So, what causes the level of volatility to change? The answer is simple, changes in liquidity. When money comes into asset markets, it drives prices up and dampens volatility: buyers carefully pick prices to pay which gives sellers the same luxury. When money comes out of the market, buying dries up and sellers are forced to sell at market prices causing volatility to pick up rapidly. Buyers don’t’ have to buy, but sellers usually have to sell.
So, what affects liquidity or the level and velocity of “money” moving in or out of markets.
First, “money” is created in two ways: the production process converting resources into income and credit expansion. When the economy picks up and GDP and profits are growing, money is being created in the sense that its value and its purchasing power is rising. We don’t see this of course because at the same time the Fed is increasing the supply of money, so we actually see more dollars/liquidity coming into the markets with those dollars having a greater affect. When the Fed increases the money supply it is really creating credit, so when the economy is expanding money is flowing into markets through income generation and credit expansion. Of course, the Fed can and has expanded credit when productivity is not increasing; in fact, credit expansion has been the primary source of market liquidity in recent decades. In 2008 we found ourselves with too much debt to by supported by the level of income generation and asset prices crashed as credit creation reversed and liquidity went to zero.
Which leads us to our second driver of liquidity, sentiment. Sentiment is really time preferences: the longer the time horizon, the more risk will an individual or institution assume. Money needed decades from now for retirement can take more risk than money needed in a few years for retirement. If markets were fully rational, time preferences would be determined solely by deductive logic. Unfortunately, human nature is just as much inductive as it is deductive. When stock prices are at all time highs, inductive logic drive investors into believing that high stock prices are telling us all is well and stocks are going higher.
Sentiment is high and causing us to take more risk than we should. The more risk we take, the more money we take out of cash and put into risk, making prices go even higher.
One of the most important functions of the Fed (in their minds) is to keep sentiment high and the money flowing into risk. Apparently, they believe that high sentiment, even when it shouldn’t be, keeps expansions going longer. They may be right, but it also makes the eventual correction even worse. This process led us to 2008, and it will lead us to it again.
As noted many times, sentiment is not a timing mechanism, but the warning is still appropriate.
The Fed is attempting to engineer a "soft landing" for the first time in history.
Given the numerous global imbalances and credit bubbles it's Mission Impossible.
Mike "Mish" Shedlock