The volatility trade casino

Ananth points to two links that highlights the casino that implied volatility trading has become. 

The market for exchange traded products (ETPs) in equity implied volatility, VIX futures, has exploded spectacularly with handsome returns since the turn of the decade. In the turmoil early last week, short positions which had been built up in the confidence complacency arising from the recent period of extraordinary stability in VIX, despite several signatures of bubbles, unravelled over just a few hours. Sample this, 

The scale of the returns the trade offered dulled the risks. Buying the largest short volatility ETP — run by Credit Suisse and known by the ticker XIV — at the start of 2015 and holding it to the end of 2017 generated a return of 320 per cent. Holding it from the start of 2015 to after Monday’s eruption, resulted in a total loss of 85 per cent... There are about 40 Vix-linked ETPs, according to Goldman Sachs, and most allow investors to bet on volatility rising... many have become popular, ranking among the most frequently traded exchange products, and rivalling the stocks of companies such as General Electric. 

And the systemic consequences have been, like with commodity futures, less than benign, with futures trading fuelling feedback loops into VIX itself,

“Volatility has become both an input for risk-taking, and something you can trade,” says Christopher Cole of Artemis Capital Management. “Volatility has become a player on the field.” In turn, the behaviour of the ETPs has helped fuel the Vix contracts that form their basis. So much so that it has led to concern that the financial products built to make money from tracking the Vix are now feeding back into the ingredients from which Vix is calculated. Traders say that at the end of Monday, the ETPs that ran into trouble from an initial rise in Vix scrambled to cover positions by buying large amounts of Vix futures, sending the price of the contracts soaring. The Vix, in turn, rose further and the S&P 500 sank.

And how did the markets respond to the unravelling of short positions - by swinging to the other extreme with the biggest ever weekly change into long-positions and the highest level of net long positions as a share of open interest in VIX futures since December 2009! 

Japan and the monetary policy debate

The ongoing monetary policy debate has its origins in Japan and its extraordinary, nearly two-decade long deflationary conditions. Now that Japan-like conditions pervade economies on both sides of the Atlantic, the search for policies that can restore growth when a country faces deflationary liquidity trap conditions and interest rates have touched the zero-bound has become the central question in modern central banking.

Conventional monetary policy loses traction in these conditions, forcing central banks into following unconventional quantitative easing policies. They involve leveraging the central banks' balance sheet to purchase securities of varying types and maturities and thereby inject liquidity into the markets. Central Banks across developed countries have been following this script over the past four years. The BoJ has so far resisted pressures to join this monetary accommodation bandwagon.

The Bank of Japan (BoJ) finally bowed to political pressures and the prevailing conventional wisdom on monetary policy making in its latest attempt to pull the economy out of a deep deflationary trap. It has announced the revision of its short-term inflation target to 2% from 1% and pledged to buy government securities in increased quantities, by renewing and expanding a bond-buying program that expires at the end of the year, to achieve that target. As part of this, after its current Y 101 trillion asset purchase program ends in January 2014, the BoJ proposes to buy Y13 trillion ($146 bn) in short-term government securities each month till it meets its new inflation target

It therefore follows the path of the US Federal Reserve (Fed) and the European Central Bank (ECB) in engaging in quantitative easing to achieve nominal anchors. Though the other two have committed to undertake "limitless" QE, the BoJ has so far refrained from going down that path. Furthermore, as the FT wrote, the details of how it proposes to achieve the 2% target is vague and does not appear to be credible enough to achieve its inflation objective,

But many analysts noted what it did not do: expand the scope of this year’s bond-purchase plans; raise the limit on the maturities of the bonds it buys beyond the current three years; or cut the interest rate it charges commercial banks for overnight borrowing. All had been suggested as steps it might take in pursuit of the new inflation objective... It left its forecast for rises in benchmark consumer prices in fiscal 2013, which begins in April, unchanged at 0.4 per cent. For the following year, it nudged its prediction up by one-tenth of a point to 0.9 per cent.

All this means that the BoJ itself does not believe that its policies will achieve the revised inflation target. It also gives the impression of a central bank stonewalling the perceived assault on its autonomy, despite the apparent ineffectiveness of its policies and the dominant current sweeping central banks across the world. It makes further political pressure on the BoJ to do more to reflate the economy inevitable.

In fact, it looks increasingly certain that Shinzo Abe will have the last laugh, since the tenure of the current Governor and his deputies ends in April this year and will most certainly be replaced with more accommodative candidates. The markets will then perceive that the BoJ's autonomy has been compromised. But the BoJ will have none but itself to blame for not showing the minimal political nous necessary to acknowledge the reality that monetary policy, especially in such times, is a deeply political decision. Its intransigence left the Shinzo Abe government with no choice but to force the BoJ to fall in line.

This follows an aggressive push by the new Shinzo Abe government, which has already initiated a 10 tillion Yen ($112.8 bn) fiscal stimulus program. The program is aimed at boosting growth by 2 percent and runs the risk of aggravating Japan's already high debt-to-GDP ratio of 220%. The Japanese government has already spend 60 trillion Yen on stimulus programs till date. Since the funds for the latest stimulus program will have to come by issuance of government bonds, it is certain to weaken the yen against the dollar and thereby also contribute towards improving the competitiveness of Japanese firms.

In this context, long-time Japan expert, Adam Posen has raised doubts about whether Japan requires another round of fiscal stimulus. He argues that Japan's big problem is deflation and over-valued exchange rate, which can be addressed through higher inflation target and more aggressive quantitative easing, and more fiscal spending would only add to the country's public debt burden.

But Paul Krugman points to a recent paper by  Paul McCulley and Zoltan Pozsar who argue that in Minsky-like cycles of leveraging and de-leveraging, monetary policy can be effective only when it is paired with fiscal stimulus. They write,

What matters is not monetary stimulus per se, but whether monetary stimulus is paired with fiscal stimulus (otherwise known as helicopter money) and whether monetary policy is communicated in a way that helps the fiscal authority maintain stimulus for as long as private deleveraging continues. Fiscal dominance and central bank independence come in secular cycles and mirror secular private leveraging and deleveraging cycles, respectively. As long as there will be secular debt cycles, central bank independence will be a station, not a final destination. 

In any case, apart from the pursuit of inflation, such competitive debasement of currency will also affect have repercussions in the foreign exchange markets. Aggressive quantitative easing and resultant liquidity injections will inevitably put downward pressure on currencies. It is now widely accepted that the Fed's QE has contributed in no small measure to depreciating dollar and increased American export competitiveness.

A weaker currency with its positive impact on exports is likely to provide governments with an irresistible temptation to indulge in competitive devaluations. In Japan, the appreciation of yen in recent years has caught the attention of the new Prime Minister Shinzo Abe, who has even called upon the central bank to target an exchange rate of 90 yen to a dollar. This has prompted Jens Weidmann, Bundesbank President, to caution against the trend of central banks losing autonomy and their decisions getting politicized. In particular, he warned about potential "currency wars", as governments force central banks into devaluing their currency to boost exports.

Commodity prices and financial markets

One of the most interesting economic debates of the last few years has been that about the influence of financial market speculation on commodity prices. See here, here, here, here, and here. The sharp volatility in commodity prices, most spectacularly manifested in the case of oil, generated widespread scrutiny of activities in the commodities markets.

Economists like Paul Krugman pointed to the absence of any abnormal inventory build-up and backwardation (futures lower than spot prices) or weak contango (futures ruling higher than spot prices) in futures market prices, and rejected the speculation hypothesis and held the view that commodity price volatility was a reflection of underlying demand-supply conditions, especially in th emerging economies. However, others like Guillermo calvo and even the popular perception was that these price distortions were caused by the large investment flow to commodity indices - the total value of various commodity index-related instruments purchased by institutional investors increased from an estimated $15 billion in 2003 to at least $200 billion in mid-2008.

In this context, RTE points to a recent working paper, where Ke Tang and Wei Xiong have found that commodity prices have become increasingly co-related with one another and with stock prices. Examining the financialization process of commodities precipitated by the rapid growth of index investment to the commodities markets since the early 2000s, they write,

"We find that concurrent with the increasing presence of index investors, commodity prices have become increasingly correlated with the world equity index and US dollar exchange rate, and with each other. In particular, this trend is more pronounced for commodities in the two popular commodity indices, the Goldman Sachs Commodity Index (GSCI) and DJ-UBS indices. As a result of the financialization process, the spillover effects of the recent financial crisis contributed substantially to the large increase in commodity price volatility in 2008.

... while there was a small negative return correlation between the GSCI index... and the Morgan Stanley world equity index prior to the early 2000s, we find the emergence of an increasing trend in the correlation between the GSCI index return and the world equity index return, concurrent with the increasing presence of index investors in the commodities markets in recent years. There is also an intensifying trend in the negative correlation between the GSCI index return and the US dollar exchange rate in recent years. For individual commodities, we find that in recent years, their returns have become not only increasingly correlated with the world equity index and US exchange rate, but also with the oil return."

Food price inflation and speculation

Businessline has this graphic capturing the price trends for 16 major food items over the year, which have cumulatively shown a 35% increase in price.



In response to mounting pressure linking increases in prices to futures trading, the Government had banned trading in wheat, tur, rice and sugar futures since last year.

However, contradicting the commonly held view that speculative activity is behind price increases, based on the aforementioned price trends, it is being claimed that "there was a nil or modest rise in prices of traded items, price rise was maximum in articles such as vegetables, fruits, tur, rice and sugar that are not traded".

Further, the price of wheat has been remarkably stable, despite the government lifting the ban on its futures trading since May this year. The price of sugar has risen by nearly 50% since sugar futures were banned in May, on the face of fears that speculative activity was behind price rise.

CP Chandrasekhar and Jayati Ghosh draw attention to the sharp spikes in commodity (both foodgrains and cash crops) prices since second half of 2007 and early 2008 and the absence of any satisfactory enough demand-side explanation for such price increases to lay the blame on the doors of speculative activity triggered off by the flood of capital into deregulated exchange-traded futures and over-the-counter forward markets. See also this on the pronounced impact of global foodgrain price volatility on developing countries.

The arguement of Chandrasekhar and Ghosh rests on the claim that foodgrain prices have been experiencing larger than normal volatility in the last few years, as these graphics indicate





However, this inflation adjusted long-term graphic of foodgrain prices appears to indicate that the inflexion of 2007-08 may not be as large an outlier as is being made out ...



... and this graph of annual international price indexes for food and energy raw materials, 1960 to 2007 (2000 = 100)



However, it cannot be denied that speculative activity may have had atleast some effect on sugar prices, by way of the impact of futures price signals on wholesale market prices (and then transmitted down to the retail market). The true extent of this impact can be gleaned only by closely comparing and examining the spot prices with the prices of sugar futures (not able to lay hands on data). But given the imperfections in the transmission of such signals here, it may only have been a minor contributory factor towards the rises in prices.

Further, see also this, this, and this examination of the reasons for the commodity price increases. Also this Vox article which feels that the food price volatility wll persist.