Has ECB head Mario Draghi lost his soft touch? Photo by Bloomberg/Getty Images.
ECB head Mario Draghi doesn’t care about your risk tolerance. Well, ok, we didn’t ask him specifically about you, but at the press conference following Wednesday’s policy announcement (in which the ECB held rates and quantitative easing, or QE, asset purchases steady), Draghi seemingly shocked a battery of reporters by stating his belief financial market volatility (most notably, in eurozone sovereign bond markets) would remain—because of QE. And that he would do nothing about it! Headlines went wild Thursday, suggesting maybe Mario had lost his soothing bedside manner. Failed! But Draghi’s true failure Wednesday was actually in his attempt to explain and forecast bond market volatility. You see, bond markets aren’t very volatile presently. And no one can forecast volatility.
Here is the principal question in … ummm … question:
Question: There was a recent rise in yields in a number of government bonds sectors in Europe, especially in Bunds. Could you give us your assessment of that? Was this a positive development that follows the recovery of the economy or was it an unjustified tightening of conditions? And is there a fear, or concern, in the Governing Council that QE may be adding to volatility in markets?
And here is Draghi’s answer:
Draghi: Yes indeed, there was some reversal generally in financing conditions recently. There have been many explanations that have been given, one of which you hinted at, namely that there is an improvement, in the perspectives of growth. A second explanation is higher inflation expectations. A third explanation is actually a bunch of technical conditions present in the markets like, and here I’m going through them quickly, first, there have been one-directional investments into long-term maturities, and the turnaround has been quite abrupt. Second, there was strong supply pressure, in the sense that issuance had been quite significant, by various governments in the meantime. Third is that when shorter-dated German Bunds became eligible, previously they had not been, because of their negative yields, there was less need to buy longer-dated bonds, and that produced a steepening of the curve. The fourth technical condition is simply that volatility by itself generated further volatility and further selling, and a fifth is poor market liquidity because of the absence of certain significant investors during this period of time.
Now, it’s very difficult to distinguish between these three sets of factors, sets of conditions, so we won’t speculate exactly on what explanation is the most likely. But certainly one lesson is that we should get used to periods of higher volatility. At very low levels of interest rates, asset prices tend to show higher volatility, and in terms of the impact that this might have on our monetary policy stance, the Governing Council was unanimous in its assessment that we should look through these developments and maintain a steady monetary policy stance.
Here is our effort to translate this central-bankerese:
Rates went up in the eurozone and lots of people wonder why. Here are a smattering of possible explanations: One, folks suddenly figured out the eurozone is growing, and they now presume it will continue; two, deflation fears are gone; three (which, confusingly, has its own list of three subfactors) is folks had piled into longer and longer maturity German debt due to supply constraints on short-term debt, driving rates down, but when short-term supply became available, the reverse happened; four, volatility begat volatility; And finally, five, bond liquidity worries.[i]
We aren’t going to delve into each individually. There is no need. All you should infer from this entire passage is bond rates went up over the period of a few weeks, and no one knows exactly why. To do otherwise is to commit the fallacy we have dubbed, “searching for meaning in bouncy times.” We award Mr. Draghi points for quite deftly avoiding the search—employing far too many words and syllables for the media to see through.
But then we detract points because of Draghi’s forecast volatility would remain elevated, which presumes two key things: one, volatility is elevated now and two, future volatility can be forecast.
The peak-to-trough movement in bond yields in Germany, the US, UK and Japan year to date is below average. Which suggests that in the most meaningful sense—the absolute amount of movement—bonds the world over haven’t been very volatile. The dust up seems like a function of recency bias—folks forget what typical market volatility looks like. Hence they draw major conclusions from slight down moves, and they do the opposite from slight up moves.
As for Draghi’s forecast, it seems to hinge on this:
“At very low levels of interest rates, asset prices tend to show higher volatility.”
This means Draghi believes QE and low overnight rates are a volatility driver. Which is odd. Try, for a moment, squaring that up with the taper fears and rate-hike agita so common among investors over the last five years. Many automatically presume low rates explain why we haven’t had a correction since 2012. Heck, this seems to be the presumption underpinning the very next question asked of Draghi:
Question: Mr President, one question on that, that we have to get used to greater volatility. What are you planning on doing against that greater volatility? Are you planning on managing the yield curve going forward a bit more, or don’t you care about greater volatility?
Draghi responded by saying:
“The answer to both questions is no and nothing….”
Draghi isn’t the only person thinking low rates mean high volatility, either. Earlier this week, Europe’s insurance regulatory body, the European Insurance and Occupational Pensions Authority (EIOPA) claimed:
“The [ECB] program substantially reduced market volume for some asset classes, which significantly increased volatility,” the regulator’s report said. It said that, in the long run, the ECB’s action would improve conditions for investors, but carried short-term risks, including the fact that “the liquidity of sovereign bonds used for the [ECB] program was dramatically reduced which in turn has caused an increase of volatility.”[ii]
And heck, who knows. It has only been three months. Maybe volatility is up since the ECB launched QE. Maybe it is to blame! But before you presume that’s the case, consider broader evidence. QE didn’t begin with ECB bond buying. US QE lasted from 2009 to 2014. UK QE also began in 2009, ending in 2012. Japan has bought bonds on a massive scale since 2012. Japanese rate volatility has been below average in every year since 2009—both before and after its big QE plan launched. The US and UK have some years above, some below and some near the average.
If low rates spur volatility—or, alternatively, if they smooth typically rocky markets—a pattern should exist and hold true globally. There isn’t one. Bond market volatility in recent years has no discernible relationship to QE. (Which makes it a heckuva lot like equity-market volatility.) Sorry, it isn’t going to be that easy to forecast market zigs and zags. Folks, volatility is just volatile. It defines random. Emotional! Investors—and, arguably, central bankers—would be better served not trying to foretell the wild whims of Wall Street.
[ii] We don’t believe QE improves long or short-term conditions for investors. It flattens the yield curve, discouraging lending by reducing the profits banks earn on loans. Read this for more.