Tag Archives: VIX

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


One need not rely exclusively on the VIX to see that the markets are treating the current period more as a risk-on opportunity than risk-off.  The returns on safe-haven assets were generally lower than the returns among risk-on assets in the first half of the year.  On the one hand, the Swiss franc depreciated.  On the other hand, the Australian dollar and Chinese yuan appreciated.  And the stock market has hit record highs.

True risk is currently high

Why do I presume to second-guess the judgment of the VIX that true risk is low?   One can think of an unusually long list of major possible risks. Each of them individually may have a low probability of happening in a given month, but cumulatively they imply a worrisome probability that at least one will happen sometime over the next few years:

* Bursting of stock market bubble.   Major stock market indices hit new record highs this month (September 12), both in the United States and worldwide.   Equity prices are even elevated relative to such benchmarks as earnings or dividends.  Robert Shiller’s  Cyclically Adjusted Price Earnings ratio is now above 30.  The only times it has been this high were the peaks of 1929 and 2000, both of which were followed by stock market crashes.

Figure 2: Shiller’s adjusted P/E shows stocks at their 3rd-highest valuations since 1880.

* Bursting of bond market bubble.  Alan Greenspan has suggested recently that the bond market is even more overvalued (by “irrational exuberance”) than the stock market.   After all, yields on corporate or government bonds were on a downward trend from 1981 to 2016 and the market has grown accustomed to it.  But, of course, interest rates can’t go much lower and it is to be expected that they will eventually rise.

* What might be the catalyst to precipitate a crash in the stock market or bond market? One possible trigger could be an increase in inflation, causing an anticipation that the Fed will raise interest rates more aggressively than previously thought. The ECB and other major central banks also appear to be entering a tightening cycle.

* Geopolitical risks have rarely been higher, and faith in the stabilizing influence of America’s global leadership has rarely been lower.  The gravest risk lies in relations with North Korea, which Trump’s response has been exceedingly erratic.  But there are also substantial risks in the Mideast and elsewhere.  For example Trump threatens to abrogate the agreement with the Iranians that is keeping them from building nuclear weapons.

* In many policy areas it is hard to predict what Trump will say or do next, but easy to predict that it will be something unprecedented.  So far, the ill effects on the ground have been limited, in large part because most of the wild swings in rhetoric have not translated into corresponding legislation.  (If he really had stuck with his decision to kick 800,000 young DACA workers and students out of the country it could have caused a recession.)  But this is a time of policy uncertainty if there ever was one.

* US Congressional showdowns over the debt ceiling and government shutdown were successfully avoided in September, but only by kicking the can down the road to the end of the year, when the stakes could well be higher and the stalemate worse.

* A constitutional crisis could arise, if for example Special Counsel Robert Mueller were to find that contact between the Trump campaign and the Russian government was illegal.

Black swans are not unforecastable

The current risk-on situation is reminiscent of 2006 and early 2007, the last time the VIX was so low. Then too it wasn’t hard to draw up a list of possible sources of crises.  One of the obvious risks on the list was a fall in housing prices in the US and UK, given that they were at record highs and were also very high relative to benchmarks such as rent.  And yet the markets acted as if risk was low, driving the VIX and US treasury bill rates down, and stocks, junk bonds, and EM securities up.

When the housing market indeed crashed, it was declared an event that lay outside any standard probability distribution that could have been estimated from past data, supposedly an example of what was variously declared to be Knightian uncertainty, radical uncertainty, unknown unknowns, fat tails, or black swans.  After all, “housing prices had never fallen in nominal terms,” by which was meant they had not fallen in the US in the last 70 years.  But they had fallen in Japan in the 1990s and in the US in the 1930s.  This was not Knightian uncertainty, but classical uncertainty with the data set unnecessarily limited to a few decades of purely domestic data.

In fact the “black swan” analogy fits better than those who use the term realize.  Nineteenth-century British philosophers cited black swans as the quintessential example of something whose existence could not be inferred by inductive reasoning from observed data.  But that was because they did not consider data from enough countries or centuries.  (The black swan is an Australian species that in fact had been identified by ornithologists in the 18th century.)  If I had my way, “black swan” would be used only to denote a tail-event that could have been assigned a positive probability ex ante, by any statistician who took the care to cast the data net widely enough, but that is declared “unpredictable” ex post by those who did not have a sufficiently broad perspective to do so.

The risk-on risk-off cycle

Why do investors periodically under-estimate risk?  There are specific mechanisms that capture how market analysts fail to cast the net widely enough.  The formulas for pricing options require a statistical estimate of the variance.  The formula for pricing mortgage-backed securities requires a statistical estimate of the frequency distribution of defaults.   In practice, analysts estimate these parameters by plugging in the last few years of data, instead of going back to previous decades, say the 1930s, or looking at other countries, say Japan.  More generally, there is a cycle described by Minsky whereby a period of low volatility lulls investors into a false sense of security which in turn leads them to become over-leveraged, leading ultimately to the crash.

Perhaps investors will re-evaluate the risks in the current environment, and the VIX will adjust.  If history is a guide, this will not happen until the negative shock – whatever it is – actually hits and securities markets fall from their heights.

[A shorter version of this post appeared at Project Syndicate.  Comments can be posted there or at Econbrowser.]

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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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