Why QE, low interest rates and volatility are an explosive mix for the markets

May 20, 2013
May 20, 2013

Critics of quantitative easing (QE)—whereby central banks push down interest rates and buy up safe assets to stimulate flagging economies—have long worried about the possible unintended consequences. The point of QE is to push down the yields on safe assets like government bonds so that investors put their money in riskier assets where it can do more economic work; the worry is that too much money in risky assets could blow up in investors’ faces.

Now, even Federal Reserve chairman Ben Bernanke is hinting at asset bubbles, saying the Fed is “watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.”

But here’s the problem: It’s hard to know what “excessive risk-taking” would look like these days, because the central banks’ involvement in the markets is distorting the usual ways risk is measured. Volatility indicators like the VIX “fear index” have been hovering around 5-year lows since the beginning of 2013. The benchmark rate at which banks exchange money, Libor, has been pushed to the floor by the glut in easy money. Weird things are happening in risky markets: just look at how cheap sub-Saharan African sovereign bonds are.

In short, risk currently looks less risky than it really is. Which is why DoubleLine Capital’s Jeffrey Gundlach warned investors earlier this month, “[QE is] forcing investors to become very comfortable with a very high level of risk.” JP Morgan analysts explain, “Investors who target a stable VaR [value at risk measure, a measure of a portfolio based on the risk of its components] tend to take larger positions as volatility collapses.” Because there’s so little volatility in the markets, investor lose the ability to measure the risk in their portfolio.

So what actually happens if we are indeed mis-pricing assets? Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, spelled out the vagaries on May 17:

When the real interest rate is unusually low, investors don’t discount the future by as much. Hence, an asset’s price becomes sensitive to information about dividends or risk premiums in what might usually have seemed like the distant future. These new sources of relevant information can lead to increased volatility, in the form of unusually large upward or downward movements in asset prices.

In simpler terms: If the price of something in the future is very similar to its price today, then the price today will react very strongly any to information about the future—such as the recent signals that the Federal Reserve is planning to dial back asset purchases. And that can destabilize the market suddenly. Though it probably won’t look like 2007, “complacent investors [will be] given a painful reminder of why they were foolish to ignore the risks in their portfolio,” writes WSJ’s Vincent Cignarella (paywall).

If we believe this thinking, then so long as easy money and low rates continue, questions about the real value of assets will persist, and any small bump in the road could turn out to be a landmine.

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