The answer in 2005 was yes.
The answer so far in 2006 is not necessarily.
Every article in Saturday’s Financial Times – the paper version as well as the online version -- seemed to note in one way or another that volatility was up, in a wide-range of markets. Indian equities are the latest example -- they went on a wild ride on Monday.
Anyone who bet that large balance of payments deficits in the US – and offsetting large surpluses in Asia and the oil exporters – would generate either macroeconomic or financial volatility didn’t do well last year. Investors either concluded that there was no reason why the US deficit couldn’t get bigger, or that the adjustment process wouldn’t require major changes in important financial variables. Bill Gross:
Risk spreads and volatility levels inherent in those spreads are in many cases near historic lows and financial leverage is at historic highs. It appears that these markets expect that we will not only have strong growth but benignly strong growth for as far as the eye can see.
More academic theorists joined in. Arguments explaining why poor countries really should finance rich countries – and why the US really should be running a trade and transfers deficit of 7% of GDP despite not exporting much (or seeming to invest all that much in the export sector) gained popularity. No need to worry about a correction, let alone the possibility that a correction might be disruptive.
The last two weeks have been a bit different. Bets that unbalanced world would be a stable world don’t look as good as they used too …
I always thought betting on stability amid growing imbalances – particularly in a context where the United States largest creditors are not its best friends – was rather risky. I don’t think I am alone. Tim Geithner has warned repeatedly against betting that deficits will unwind as smoothly as they can be built up. Larry Summers has warned that fixed exchange rates can create the illusion of stability -- which isn't quite the same thing as stability. That presumably applies even if the US isn't managing its exchange, but rather watching as other countries intervene to keep their currencies stable against the dollar in the face of pressures for change.
Among other things, it seems a range of new financial instruments – including some that I hadn’t heard of until recently – are getting put to at least a modest test. Anyone an expert on variance swaps?
According to the FT, Paul Tucker of the Bank of England suggested that the explosion of new financial instruments may have helped to push the price of risk down. Certainly, the rapid growth in certain markets – like credit default swaps – has coincided with a fall in risk spreads. I am not sure if that implies that credit default swaps contributed to the fall in the price of risk, or if the fall in the price of risk just led more people to bet that it would keep on falling. But I am pretty confident that many recent financial innovations have yet to be tested in any truly trying times. Or perhaps the hedging strategies of those selling insurance against bad outcomes are what hasn't been fully tested. And it sure seems like the odds of a test – perhaps never that high to begin with -- have gone up recently.
One note: I updated this post on Monday morning to add the Indian equity price moves and the Gross quote. Incidentally, I am back in the office this week, and should be posting a bit more regularly.