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The Fed Is Worried That You Might Be Worried About Uncertainty

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When you are in the business of buying and selling volatility you can get sort of cynical about whether volatility is a thing, and whether it is appropriate to buy and sell it. We talked earlier today about the fact that if you have a client who doesn’t care about something valuable, then you should buy as much of it from him as you can; you can guess where I learned that. It is superficially persuasive to tell a customer "you don't get any benefit from the volatility of your stock so you should just sell it to us," but ultimately you can't eat volatility. You eat buying low and selling high, and so you rigorously translate the customer's sale of volatility into buying low (from the customer) and selling high (to the customer). Science!

So I started reading this San Francisco Fed note about "uncertainty" with a certain amount of skepticism. Reuters describes the finding as "Uncertainty over the economic outlook has added between one and two percentage points to the U.S. unemployment rate since 2008," and you might reasonably say "shut up, uncertainty hasn't increased the unemployment rate, expectations that things will be bad have increased the unemployment rate through perfectly unsurprising self-fulfillingness." Managers don't stop hiring just because they think things will be pretty good, but with a small chance of a delightful surprise. It's the drift, not the variance.

The SF Fed's note does not entirely dispel that concern; it measures "uncertainty" based on a Michigan consumer survey that "has polled respondents each month on whether they expect an 'uncertain future' to affect their spending on durable goods, such as motor vehicles, over the coming year," and I suppose each consumer can make his own choice about translating "uncertain" into "scary." Here is that uncertainty graphed against the VIX and I submit to you the differences are instructive:

Sure, post-2001-ish VIX and consumer uncertainty track closely, but in the mid-90s boom, stock-market variability remained high without bothering consumer confidence. Nobody stops buying washing machines just because they're worried that their stock might suddenly make them millionaires.

Still this note might usefully inform the question: what does the Fed do, anyway? (In the specific context of "when it announces a new quantitative easing program.") One obvious answer is "lower mortgage rates by buying mortgage-backed securities," which is unsatisfying, in part because the transmission between MBS and mortgage rates is somewhat broken. Another answer is I guess "lower risk-free rates to the point at which they're horribly unattractive, forcing people into risky assets," and that's fine though dull.

But here is a Sober Look / Credit Suisse argument that the (well, a) correct answer is "the Fed reduces uncertainty," or more technically "the Fed sells volatility." Credit Suisse describes that in the form of (1) the Fed buys mortgage bonds, which (2) provide a prepayment option to the seller, so (3) the Fed in effect sells prepayment options (i.e., interest rate volatility) to the market. Sober Look notes the parallel to classic Greenspan-put forms like propping up financial markets by unleashing easing whenever they crash too much, as well as the ECB's parallel support for European government bonds.

You can take this in a simple directional way - now you can prepay your mortgage when rates go down, so you do, so you have more money1 - but you can also think of it from an options perspective. A person or market that is long optionality will tend to buy the underlying when prices drop and sell when they rise. That's easy to see if the underlying is the mortgage bonds that the Fed is buying - mortgage bond prices can't go too low (Bernanke put!) or too high (prepayment option!) - but it's also true more broadly; stocks, for instance, are floored by the QEn put, but that floor loses value if they rally.2 There's some certainty on either side, and perhaps certainty, rather than just an increase in asset prices, is what is wanted.

The Bank for International Settlements' Quarterly Review is out today, and it's the sort of central-banker-y festival of graphs that you feel like you ought to mention, so, here, mentioned. One of the papers is titled "Search for yield as rates drop further," and does some official gloating about central banks' recent successes in making Bill Gross cry:

With sovereign yields at historical lows, investors increasingly looked beyond benchmark government bonds in search of reasonably safe investments offering some extra yield. Such portfolio rebalancing is one of the key objectives of unconventional [monetary] policies, intended to stimulate risk-taking by reducing the attractiveness of government securities relative to risky assets.

But it ends not on a note of "look how much [mortgage lending / corporate bond buying / funding of Spain] there is," but instead on volatility:

The volatility of risky assets remained extraordinarily subdued given the concerns about the euro area debt crisis and the poor outlook for growth (Graph 6).3 Volatility was low compared to recent history in credit, foreign exchange and equity markets. On 13 August, the implied volatility index (VIX) computed from the prices of US equity market options fell to its lowest level since June 2007. ... As a consequence, assets traditionally perceived as risky may have been less affected by the deterioration of the growth outlook and the euro area strains compared to previous episodes.

"Propping up levels" and "tamping down volatility" are obviously closely related concepts, so perhaps none of this means much. But I like the idea of central bankers and their friends focusing not just on helping the economy when its bad, but on doing so in ways explicitly designed to reduce uncertainty and volatility. After all, that is the idea of a central bank - to take countercyclical actions to reduce volatility and uncertainty. And if they build programs that do that automatically, so much the better.

Uncertainty is adding to U.S. jobless rate: Fed paper [Reuters]
Uncertainty, Unemployment, and Inflation [FRBSF]
Fed's selling volatility into the market will force mispricing of risk [Sober Look]
BIS Quarterly Review, September 2012 and Search for yield as rates drop further [BIS]

1.One can of course say, as Sober Look does, "artificially suppressing volatility creates a 'moral hazard' by forcing markets (including individuals and businesses) to misprice (and learn to ignore) risk," though one might also be wary of using the word "artificially" to describe actions by market participants, even the ones attached to printing presses.

2.It's not just a Fed thing; GM's stock is probably not going to zero, but the implicit put that government support provides loses value, and the prospect of the government flooding the market with shares increases, as it gets above $30.

3.Here's Graph 6:



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Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels: