Tag Archives: risk

The VIX is too low!

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September 30, 2017 —   During most of this year, the VIX — the Volatility Index on The Chicago Board Options Exchange — has been at the lowest levels of the last ten years.  It recently dipped below 9, even lower than March 2007, just before the sub-prime mortgage crisis. It looks as though, once again, investors do not sufficiently appreciate how risky the world is today.

Known colloquially as the “fear index,” the VIX measures financial markets’ sensitivity to uncertainty, in the form of the perceived probability of large changes in the stock market.  It is inferred from the prices of option on the stock exchange (which pay off only when stock prices rise or fall a lot).   The low VIX in 2017 signals that we are in another “risk on” environment, when investors move out of treasury bills and other safe haven assets and instead “reach for yield” by moving into riskier assets like stocks, corporate bonds, real estate, and carry-trade currencies.

Figure 1: The VIX is at its lowest since 2007

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Black Swans of August

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       Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet.   Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961.  Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007.   Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable. 

The phrase “black swans” has come to be used to mean a very unlikely event of this sort.  Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time.   This is nonsense.  If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong.  This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it.    A still better interpretation is that statistical distributions have “fat tails,” in technical terms.  But it would be nice to get beyond the Jurassic Park lesson (“don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events. 

       What does “black swan” really mean?   In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries. 

      Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.”  The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction.   But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697.  A 19th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books.  It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event.  A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

 2. “Terrorists don’t blow up big office buildings.”   Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings.   These warnings were not taken seriously by those in power at the time.   Many Americans did not know the history of terrorist events taking place in other countries and in other decades.  

 3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall.   After all, “they never had before,” which meant that they had not fallen in living memory in the United States.   They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s.  Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

 4. “Volatilities are low.”   During the years 2004-06, financial markets perceived market risk as very low.  This was most nakedly visible in the implicit volatilities in options prices such as the VIX.  But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices.  One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”).  They should have gone back much farther – or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

 5. “Big banks don’t fail.”   “Governments of advanced countries don’t default.”   “European governments don’t default.”  Enough saidGreece‘s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans.   The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk.  Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

      My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.

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A Review of Predictions of the Last Decade

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         December 31 is technically the end of the first decade of the 21st century.  It is perhaps an appropriate time to review one’s predictions.    It seems to me that I got some things right over the last decade.  Indulge me while I review the predictions that came true, before turning to those that did not work out as well.

Stock market peak     At the end of the 1990s, I felt that the dizzying ascent of equity prices could not continue into the new decade, that there was “…a bubble component in the stock market”  (Nov. 20, 1999).   This was four months before the bubble burst in 2000.  So far so good.

The Euro        Also at the start of the decade, I thought the european currency was undervalued.   My prophesy: “… there will be a major appreciation of the euro against the dollar” (June 21, 2000).  Over the next eight years the euro in fact rose 60% in value.    (But, incidentally, “I don’t mean to express an optimistic forecast regarding European economics or governance…. Europeans have made many mistakes, the leaders and public alike.” 2006.)

The Yen       In January 2008, I wrote about “…the carry from the yen to the euro:  it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro.”  (“Getting Carried Away: How the Carry Trade and Its Potential Unwinding Can Explain Movements in International Financial Markets,”  Milken Institute Review 10, no.1, pp.38-45)   By November 2008 the yen had sharply reversed, precisely in the way predicted.

TIPS           I recommended Treasury Inflation-Protected Securities to my blog readers, early in what turned out to be a period of steep rise in their value.  (Feb. 2009.)

            The big economic story  of the decade of course was its second recession, the worst in 70 years, and the severe financial crisis that caused it.    A number of economists got important parts of the 2007-09 crisis right ahead of time (although nobody got all of it right).   I give credit in particular to Krugman, Shiller, Gramlich, Rajan, Borio and White at the BIS, Rogoff, and Roubini.  A 2009 paper identifies 12 commentators as having warned that the US housing market would end in a serious recession.

What parts of the crisis did I get right?

Severity of 2008-09 recession             After the tax cuts of 2001 and 2003, I predicted that spending growth and deficits would rise rather than fall, and that the legacy of high debt would mean that the next recession would be longer and more severe than past recessions:

 “Good economic logic does not support the idea that Bush fiscal policies caused the weak economy of the last three years. Good economic logic supports, rather, a causal link between Bush fiscal policies and the next recession. The future downturn is likely to be far worse than the recent one…They also created long-range uncertainty that makes planning difficult (nobody from either party expects the relevant tax law to remain as it is currently written)… It is impossible to say when the next recession will come. But when it does, it is likely to be worse than the 2001 recession. Why? Precisely because we will enter it at a time when the budget deficit and national debt are already alarmingly high…Thus when the next recession hits, we will not have luxury of being able to cut taxes and increase spending as George II has done. … The resulting pain will make the economic travails of George II’s first term pale in comparison…”  (Oct. 30, 2003.  Also Dec.2003 and Nov.2004).    

I said it again as the downturn began:”… if the economy does go into a recession, Mr. Frankel says, “it is likely to be worse than the last one” (WSJ, 1/21/2008).

That seems to me precisely what happened.

Budget deficits   At the start of the decade:  “We need to think about using our budget surplus to provide for the retirement of the baby boom generation, not to blow it on a big tax cut” (May 16, 2001).  But of course the Administration chose the latter policy.   Like many others, I continued throughout the decade to warn that fiscal policy was irresponsible.  The “White House forecast of cutting budget deficit in half by 2009 will not be met,” and “Further, the much more serious deterioration will start after 2009.”  (May 24, 2006.)   Indeed.

Market underestimation of risk        I was dubious of the “Great Moderation.”   By 2006, I was warning frequently of serious risks facing the economy, arguing that even though the odds of each sort of possible setback were small in any given year, the cumulative probability that at least one of them would hit the economy over the next couple of years was relatively high.  (May 24, 2006.)  The markets were underestimating this risk:
 “How can the implied volatility in options prices be so low?  Perhaps investors are judging risk solely from the statistics of recent history, and not from a forward-looking open-eyed consideration of the risks facing the global economy.”  (Nov. 2006.)    “The implicit volatilities in options prices are substantially too low, and will rise.  … market estimates of risk are lower than they should be.  … the market is basing its perception of risk on recent history, not on a forward-looking assessment of the risks facing the US and global economies.    Such risks include further falls in housing or rises in oil, a hard landing for the dollar, and geopolitical risks arising from the Middle East.”   (Jan.12, 2007. And again, May 14, 2007.)     
The VIX (the CBOE index of market-expected volatility) was close to 10 when that was written.  It was to go as high as 80 when the full financial crisis hit in 2008.

The carry trade “should be reversing.” (Jan.12, 2007.)    Market perceptions of risk had “fallen to irrational lows, as reflected in the low interest rates at which governments of developing countries, unqualified American homebuyers and high-risk businesses could borrow money.” (Nov.19, 2007, and Jan. 2008.)   

International crises    When asked Have financial developments made the International Monetary Fund obsolete?” my answer was “The IMF is by no means obsolete. …. It is foolhardy to think, just because emerging market spreads have been very low recently, that there will be no more crises in the future.”    (March 1, 2007)   I identified Hungary and other Eastern European countries as particularly vulnerable.  (Jan. 2008.)

The coming financial crash       The comments I made at a Cato conference held in November 2006, shortly before the sub-prime mortgage crisis hit in 2007, look good now:

 “The Greenspan Fed probably erred by providing too much liquidity in 2001-2004….If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet; but dangers lie in the future. It is not that I am especially worried about inflation at the moment. … what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation…”     (In Responding to Crises, Cato Journal, Spring 2007.)

Housing          Of the various asset markets, housing was the area where policy had most clearly gone awry.    I had long thought “that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising.”   (March 26, 2007.)    “Many people bought houses they could not afford unless prices continued to rise rapidly or real interest rates remained extraordinarily low, which predictably did not happen.”  (April 28, 2007.)     

The start of the recession     “[A]t the time of writing [Jan. 2008], the United States appeared to be poised on the brink of recession….A coming recession may be more severe and long-lasting than the last one in 2001….”   By May 2008 I had figured out that a recession was indeed probably underway– at a time when some Administration officials were still ruling it out and indeed GDP figures appeared to show positive growth in the first part of that year.   

Banking crisis resolution       When the Obama Administration announced its revised form of the Bush Administration’s Troubled Asset Relief Program, I argued that maybe they actually knew what they were doing and that the plan should be given a chance to work.  (March 23, 2009.)  I felt pretty isolated.  Others attacked the plan, from both left and right.  They expected Tim Geithner’s stress tests to be phony.  The critics were sure that the taxpayer would end up paying hundreds of billions of dollars to bail out the banks.  They wanted either to nationalize the banks or leave everything to the free market.  As things developed, however, financial collapse was averted without nationalization and the banks have since repaid the Treasury with interest.   

The trough      Financial markets stabilized in the first half of 2009.  Turnarounds in the rates of growth and job loss led me to believe in the summer of 2009 that the economy had probably hit bottom by then.   This turns out in fact to have been the case: The record shows that the recession ended that June.

Predictions gone wrong          Needless to say, I got plenty wrong in the decade as well.   For one thing, I kept expecting U.S. long-term interest rates to rise, because of the alarming long-term fiscal profile. Yet the bond market correction never came.   For another thing, based on econometric estimation of reserve currency holdings, Menzie Chinn and I projected that the euro might eventually rival the dollar in international currency use by 2015 or 2022.    It now seems unlikely.   I certainly thought that the sort of financial crisis that began in the U.S. in 2007-08 would be accompanied by a fall in the dollar.  Yet flows into the U.S. showed that the dollar is still a safe haven.  For this reason I abandoned my euro-bullishness, even before the mismanaged Greek crisis in early 2010.

My most spectacularly wrong predictions were all in the area of politics.  I had thought that if any presidential candidate gained the White House without winning the popular vote, his entire term would be consumed by divisive efforts to reform the Electoral College.   (This did not happen after January 2001.)   I had thought that if a high-casualty international terrorist attack hit the U.S. (September 11, 2001), American foreign policy would thereafter become ruled less by jingoism and more by expertise.  (Not!)   In 2008 I suspected that a Democrat who was perceived as a northern liberal could not be elected president.   (Wrong again.)  

In the coming decade, I resolve to eschew political forecasts, and stick to economics.

[Comments can be posted on the Belfer site.]

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