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What have we been up to


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All eyes on the ECB in a very uncertain world

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This is a fairly quiet week from a data release and central bank speakers’ point of view, despite Washington DC having played host to the world’s central bankers this weekend at the IMF and World Bank’s annual meeting. For the first time in quite some time, much of the focus is not only on what central bankers might utter with regards to monetary policy - and the timing and extent of tightening in the face of rising inflation and an improving global economy -  but also on who will be leading the Fed should Trump decide not to reinstate Yellen. White House officials have confirmed that the Fed Chair search has been narrowed down to five candidates, and Trump is expected to announce a decision before he leaves for his Asian trip on 3 November.

The candidates include Janet Yellen, former Fed Governor Warsh, Stanford's Taylor, Fed Governor Powell and National Economic Council Director Cohn. According to the bookies, Yellen is an outsider to keep her position - though, if she were re-elected, markets would likely enjoy the status quo at the Fed. She also fits the dovish bill, and Trump is a self-proclaimed ‘low rates guy’. At the other end of the dove/hawk scale is Taylor: one assumes Trump is aware of the famous ‘Taylor Rule’ which foretells a possible sell-off, with the correspondent higher interest rates, should the Stanford Professor of Economics be elected. 

In terms of what could move financial markets this week, investors will be keeping an eye on the US shaping up for more drills in the North Korean peninsula – along with any more sabre-rattling from Kim Jong-un or Trump; PM May attending more impromptu meetings in Brussels; and both Draghi and Yellen speaking. Attention will then turn to the back-end of next week with the Bank of Canada rate statement followed by the highly anticipated ECB press conference, and the rate decision, this Thursday.

It’s not difficult to point to all manner of risks that could have major knock-on effects in financial markets, beyond those mentioned above: Catalan separation, US economic policy, Turkey’s diplomatic row with the US, China’s credit bubble, undercapitalised major European banks, Peshmerga, (hard) Brexit, North Korean nuclear escalation…. Juxtaposed against this clearly uncertain financial and geopolitical backdrop, volatility trends and developed market equities continue to reach all-time lows and highs respectively. Both phenomena are backed up by the ultra-loose monetary policy that equity owners have so enjoyed. Conversely, anyone who is long volatility has had to bear considerable pain. Volatility, or lack thereof, has caught the eye of many alternative investors keen to cash in on a market that could be ripe for a change in tack. Bloomberg cites a growing number of hedge funds looking to set up so-called long volatility funds, designed to protect investors from rising market turbulence. The ECB’s Knot, who is also President of the Dutch Central Bank, feels “uncomfortable to have low volatility in the markets on the one hand while on the other hand there are risks in the global economy,” – at the same time reassuring those going short volatility that “no one within the context of the ECB is already talking about an increase of interest rates”. Rates will “stay low for a long time.” After winning the Nobel Prize in economics last week, Richard Thaler summed up the conundrum: “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”

Central bank policies are the driving force behind this low-volatility environment. Monetary accommodation is now being gradually withdrawn after a protracted period of being ultra-loose, with the ECB now (crucially) anticipated to join other central banks at some point. This implies that there could potentially be an about-turn in the low-volatility status quo. Furthermore, according to the CFTC, VIX futures and options markets show a new record short position in the VIX. Any requirement to unwind this position could ‘short-squeeze’ the market and is likely to send the index spiking. These factors go a long way to explaining why, despite all the potential risks to financial markets highlighted.

All views expressed here are the author’s own and are based on information available at the time of writing.




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