It's raining vols

Wednesday, November 05, 2008

So at last, the election is over. After weeks of facing accusations of being an Obama supporter in the office and an Obama hater in cyberspace, Macro Man can go back to focusing exclusively on markets and macro.

Markets seem to be in some sot of weird limbo at the moment. The acute feeling of crisis seems to have passed, yet has hardly given way to any sort of euphoria. As is generally the case, the slow grind higher is the most painful follow-through to a drop down the elevator shaft.

Anyone left long vol has probably not had a good week; Macro Man had the uncomfortably surreal experience of being long USD/JPY upside and losing money yesterday even as spot rallied a percent from his marks on Monday. Someone summon the Weather Girls, because it's raining options.

The problem at the moment is perhaps encapsulated by the chart below, which shows the risk appetite index that Macro Man follows. Last month it went nearly eight standard deviations into risk aversion, a level that eclipsed even the panic readings of October 1987. And while it has retraced much of the move into risk aversion, it still sits a level more than two standard deviations below neutrality- in normal circumstances an extreme reading. These normalizations are always painful if you're left long vol, and this wee has been no exception.
Looking ahead, it is reasonable to conjecture what an Obama administration might mean for the dollar. He's already been more bullish for the dollar than Bush, insofar as the dollar came under immediate, significant selling pressure the day after Election Day 2004. EUR/USD has had the temerity to decline 1% today (albeit after a sharp yesterday.)

More broadly, it is probably legitimate to consider how the array of measures being conducted by the Fed will impact the dollar. The quantitative easing currently underway- and let's face it, that's what's going on here- is significantly expanding the money supply, which a priori could be construed as bearish for the dollar.

And at first glance, the argument would appear to hold water. The chart below shows USD/JPY overlaid with the evolution in the relative sizes of the monetary bases in the US and Japan. And as you can see, the relationship appeared to explain a good deal of the swings and roundabouts in USD/JPY from 1990-2001, when Japan pursued orthodox policy measures to (unsuccessfully) combat its domestic depression/deflationary spiral.
In 2002, however, the BOJ adopted a radical policy of quantitative easing, which drastically exapnaded the BOJ's balance sheet and, by extension, the monetary base. And what happened to the yen? Not a whole lot. Based on a similar scale to the chart below, a simple overlay would suggest that the yen should have weakened to nearly 200 vs the dollar. Instead, it went broadly nowhere.
Why is this? Primarily because this "new money" generated by quantitative easing a) went to offset money that disappeared as non-performing assets were written down, and thus stayed on banks' balance sheets, and b) the remainder was placed with the BOJ.

It was only in 2005, when conditions began to fall into place to encourage the end of quantitative easing, that the wall of money (both institutional and Mrs. Watanabe) began to leave Japan.

This is a not dissimilar outcome to EUR/USD in the early Noughties; the dollar only really began to weaken dramatically when the economy started to pick up noticably and policy began to look demonstrably easy.

Macro Man can't shake the belief, therefore, that while the current alphabet soup of measures might undermine the dollar....that might be a story for the next Administration, whoever it may be.

Posted by Macro Man at 9:27 AM  


Should that not be "REL JAP/US MON BASE"? How can usd/jpy appreciate when there are more dollars to each yen?

Anonymous said...
12:45 PM  

Yes that is correct.

Macro Man said...
12:59 PM  

The scale to the right is inverted, so US/JAP MON BASE makes sense.

Macro man,

Do you really believe monetary policy can solve a Japan situation? Krugman wants the BoJ to create inflation expectations of 4% and expand their balance sheet until inflation reaches that level. The central bank would buy every debt there is. But people who don't want to invest can not be forced to invest. They will just exchange their cash for precious metals or other real goods. Keynes will be found dead in the control room once again, like in the 70s.


Anonymous said...
1:16 PM  

Johan, I think that quantitative easing in Japan DID effect a meaningful change in japan's economy and financial system, allowing the banks to finally clean up their balance sheets and begin lending again.

Macro Man said...
1:26 PM  

yesterday our beloved TY(10 yr note futs)looked over at the dollar -2 and said 'i can do this', and shot up +1.5 points...the problem seems to be the sovereign wealth funds can yank things the way they want to go 'crazily' due to relatively unlimited capital and the poor hedge funds and banks must react...stock indexes did turn in the usa midnite hours as FTSE tagged 50day ema...i'm looking for big turns after the nov. 15th last day for hedge fund redemption notices, which coincides with bretton woods II world leaders meeting...TY bulls should like our non farm payroll shrinkage this friday...
creditfixings dot com for glitner cds

Anonymous said...
1:31 PM  

With regard to the usd/jpy-monetary base analogy - where should the status of trade/budget/savings deficit in US vs surplus in Jpn come in play in respective historical contexts? If so would the inclusion of such consideration make the analogy distorted?


Anonymous said...
1:43 PM  

Hello Macro,

is your risk index proprietary, or can you reveal what goes into it?


Anonymous said...
2:29 PM  

Proprietary, unfortunately, though it is similar in spirit to those calculated by a number of sell side banks.

Macro Man said...
2:46 PM  

This chart of relative monetary growth versus USDJPY seems a classic example of a temporary spurious correlation. (if there was any relationship, ever, it broke down in 2002)

Everyone trading currencies knows forex rates are driven primarily by investment flows -- the yen carry trade has certainly broken down in the last few months. This isn't about money supplies -- its about risk aversion (as your article also states) and reluctance to issue credit.

During the last couple months, the Fed's balance sheet has literally doubled from $1 trillion to $2 trillion-- 100% growth. But your chart is claiming only a minor difference in monetary growth rates?

Correlation (when it exists) does not prove causation -- and in this case it is far from obvious the "correlation" wasn't just a temporary phenomenon created by your choice of graph scales

Anonymous said...
3:01 PM  

MM: Looking ahead, it is reasonable to conjecture what an Obama administration might mean for the dollar. He's already been more bullish for the dollar than Bush...

Another spurious correlation.

Obama wasn't even president elect until yesterday -- on what basis do you claim he is dollar bullish?

There is general agreement that the USD was oversold heading into the election season... so technically it might have bounced even if Bush was somehow allowed to run again.

There has been massive deleveraging and unwinding of carry trades -- reflecting risk aversion and the need for overlevered banks/hedge funds to delever. Its hard to argue that carry trades wouldn't be unwinding no matter who the presidential favorite was.

Anonymous said...
3:14 PM  

It's "obvious", except for the fact that some market practitioners used to use this very measure to successfully predict trends in USD/JPY a dozen years ago.

The Fed's balance sheet has expanded dramatically, but to date the monetary base growth has been less exaggerated. The data is what it is.

Oh...and I first generated this chart in 2001....and haven't changed the scales since. Arbitrary, perhaps...but enduring.

Macro Man said...
3:15 PM  

Do you even bother to read the posts?

Last election, the dollar got shagged from the moment Bush was announced the victor. This time, it rallied for 12 hours (though is now getting shagged.)

That is a more bullish outcome than last time.

Macro Man said...
3:23 PM  

So the fact that the dollar is getting shagged now somehow "proves" that Obama is dollar bearish?

Come on...

Its not as though Obama's victory wasn't widely anticipated. Why would forex traders wait for his victory speech to buy the dollar if Obama was the cause? Are you suggesting forex traders are mentally slower than the rest of the population?

Anonymous said...
3:37 PM  

Your first chart (through 2001) has a left hand scale (and a "better" spurious fit) from 75 to 175...

but the later chart (through 2008) has a left hand scale (and a worse spurious fit) from 75 to **200**

175 max is not the same scale as 200

Anonymous said...
3:40 PM  

a) The 1990-2001 was in fact created today, and yes I adjusted the scale to reduce the amount white space.

b) The Obama/dollar comments were flippant throwaways. You really need to get a sense of humour.

c)I don't mind criticism, but confrontational nit-picking isn't something I am prepared to deal with. From inception the tone of the comments section here has been professional and polite. Keep it that way.

Macro Man said...
4:11 PM  

MM -- take a few deep breaths and smile...

You just proved that you are human, like the rest of us.

The reason we all read your blog each day is because you are generally more right than wrong

Anonymous said...
5:15 PM  

US Treasury announced a massive, but as-expected, $55B quarterly refunding hitting next week...looking at TLT, high o week a 50dma touch and low o week a 200 dema touch...

Anonymous said...
5:22 PM  


Maybe the breakdown in the correlation was an unusual -- even six sigma -- event? Too many assume that what happened in Japan will happen here. I think its a bit misguided.

Here's why: Japan was able to walk the tightrope between a deflationary crash and an inflationary spiral. Sure they had some deflation, but overall, they weathered a full-blown credit crisis with comparatively little pain and instability. I say comparatively in the context of history, where either deflationary depressions (the U.S. 1870-1939) and inflationary spirals (modern emerging markets, post-war Japan and Germany) are the norm. (btw, I'd warrant that what determines deflation vs. inflation is the level of domestic savings).

So we're expected to leap off the credit precipice and land on the same tightrope as Japan? I can come up with a host of reasons for why Japan is the exception rather than the rule.

David Pearson said...
8:12 PM  

Hey, the point of the chart was simply to demonstrate that it is not axiomatic that quantitative easing generates currency weakness. I think it accomplishes that.

The US situation differs from Japan in a whole host of reasons, three major ones being that a) Japan was dealing with the simulataneous collapse of property and equity bubbles, b) that Japan was a net creditor, and c) that Japan farted around for ten years, give or take, before forcing banks to write down bad assets and providing a quant easing context for them to rebuild.

How will the US situation play out? I don't know. But I would bet that the country will have come through this in five years time, unlike the Japanese.

Macro Man said...
8:42 PM  


Don't get me wrong the charts are great work and much appreciated.

You're right about the conclusion from the charts. The question is whether its a rule or an exception. I think the latter is much more likely given the weight of historical analogies. Or rather, I think the market consensus that Japan is the appropriate analogy is so widely held as to be extremely risky. Risky because in many respect Japan's post-crisis adjustment was striking in its stability.

David Pearson said...
8:59 PM  

At first I wanted to bring up the unique keiretsu system in Japan, and its systematic mispricing of debt, and the for too low cost-of-capital for (buddy) firms. And then I realized this is precisely making the (opposite) point...

cfarley said...
10:19 AM  

Macro man, how is the risk appetite index calculated?

Yuksel said...
6:11 PM  

Macro Man,

As a non-confrontational nit-pick, it should be borne in mind that the US now pays interest on the reserves part of the monetary base, so what is expanding is not quite the same as it was. In fact, the Fed is paying interest on reserves in order to effectively sterilise them and the expansion of excess reserves is really a bi-product of longer term Fed lending (eg the TAF).

RebelEconomist said...
11:27 PM  

What is the reason for decreased correlation b/w USD-JPY and risk-appetite after QE?

Anonymous said...
8:36 PM  

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