Thursday, 16 August 2018

What's wrong with euphoria?

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  • Shah June 24 2014

Divyang Shah on the tricky art of containing tail risks. 

Here we go again. It almost sounds like the BIS is looking to provide central banks with an excuse to normalise monetary policy by dusting off warnings over market “euphoria”.

But behind the usual concerns over low vol, complacency and excess, there is a much more serious message about market structure. If and when markets decide to head for the exit, the risk is that things become very violent as there are very few willing risk takers on the other side.

…if the market continues to ignore the risks, such warnings might be seen as crying wolf and in the same light as Greenspan’s irrational exuberance in the mid-1990s

No matter how much policy makers talk about financial stability concerns, they are not in the business of putting an end to the party. Macroprudential tools provide central bankers with something extra to play with, but only monetary policy can get into “all the cracks”, in the words of ex-Fed’s Stern. If anything, the use of macroprudential tools helps to limit the most extreme tail risks that come along with a bursting of the bubble. We saw an example of this tail risk focus in action last week when the BoE decided to limit its tolerance for future excesses in the housing market rather than directly constrain prices.

This is the same thinking that is behind central bankers’ worries over market euphoria. In their desire to grab yield by moving down the risk spectrum, there are signs that investors are willing to tolerate a lower liquidity risk premium. Since the start of the financial crisis, we have witnessed a reduction in the number of willing risk takers, especially when the market becomes volatile. Along with a lack of liquidity, we also have a lack of market depth, and these become more significant during less euphoric times.

Positive correlation

Low implied/actual vols and returns that are positively correlated mean that investors are more likely to misprice the liquidity risks involved, especially when demand for yield is so strong. Just take a look at what happened during last year’s taper tantrum where a NY Fed study suggesting that an unwillingness by dealers to “supply liquidity amplified the sharp rise in rates and volatility” during May and June 2013.

Warning investors that they are not being adequately compensated for liquidity risk is a start. But if the market continues to ignore the risks, such warnings might be seen as crying wolf and in the same light as Greenspan’s irrational exuberance in the mid-1990s.

More likely is that policy makers will look to directly control the tail risks related to a lack of a liquidity premium such as the recent report in the FT that the Fed has been looking into the possibility of imposing exit fees on bond funds to avert a potential run by investors.

Higher interest rates will likely remain the main tool for central banks with a recognition that the sporadic use of macroprudential/regulatory policy is also required to deal with tail risks from financial stability concerns.  

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