Will Central Banks Ease Monetary Policy?

The VIX Volatility Index is signalling investor confidence in the markets.

Stocks and interest rates are back to late spring – pre latest European fear levels – and the Jefferies/Thomson Reuters CRB commodities price index is at a three-month high.

Risk assets are obviously back in favor with investors – possible action by the European Central Bank (ECB) and the US Federal Reserve (Fed) could offer an explanation why:

  • There is speculation Fed Chairman Ben Bernanke could signal another round of quantitative easing at the Jackson Hole, Wyo. end of August Fed meeting.
  • ECB President Mario Draghi promised to defend the euro so markets are expecting a move from Europe’s central bank.

The CBOE Market Volatility Index, the VIX or “Fear Index” as it’s known recently hit its lowest level since the global credit crisis erupted five years ago.

Mike Dolan offers us an explanation of what the VIX is and questions why such high levels of investors complacency…

“Given almost biblical gloom about the world economy at the moment, you really have to do a double take looking at Wall Street’s so-called “Fear Index”. The VIX, which is essentially the cost of options on S&P500 equities, acts as a geiger counter for both U.S. and global financial markets.

Measuring implied volatility in the market, the index surges when the demand for options protection against sharp moves in stock prices is high and falls back when investors are sufficiently comfortable with prevailing trends to feel little need to hedge portfolios. In practice — at least over the past 10 years — high volatility typically means sharp market falls and so the VIX goes up when the market is falling and vice versa. And because it’s used in risk models the world over as a proxy for global financial risk, a rising ViX tends to shoo investors away from risky assets while a falling VIX pulls them in — feeding the metronomic risk on/risk off behaviour in world markets and, arguably, exaggerating dangerously pro-cyclical trading and investment strategies.

Well, can that picture of an anxiety-free investment world really be accurate? It’s easy to dismiss it and blame a thousand “technical factors” for its recent precipitous decline. On the other hand, it’s also easy to forget the performance of the underlying market has been remarkable too. Year-to-date gains on Wall St this year have been the second best since 1998. And while the U.S. and world economies hit another rough patch over the second quarter, the incoming U.S. economic data is far from universally poor and many economists see activity stabilising again.

But is all that enough for the lowest level of “fear” since the fateful August of 2007? The answer is likely rooted in another sort of “put” outside the options market — the policy “put”, essentially the implied insurance the Fed has offered investors by saying it will act again to print money and buy bonds in a third round of quantitative easing (QE3) if the economy or financial market conditions deteriorate sharply again.” Mike Dolan, Put Down and Fed Up, blogs.reuters.com.

There is no doubt in this author’s mind most people believe the world’s governments and central banks will step in with some form of quantitative easing. Current market conditions are clearly showing this. If Draghi and Bernanke come through, commodities would seem like a good place to have my money.

By Rick Mills

Richard Mills, author and host of Ahead of the Herd, is an active investor and commentator in the junior resource sector. Rick’s work covers the spectrum of company analysis and macroeconomics.

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