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Wed Nov 2 10:08:58 PST 2005

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JAPAN'S ECONOMY
Nov 1st 2005  

Financial markets have been eerily calm for most of the past two years.
No longer

IT'S not easy sleeping in the Buttonwood family home. The problem is
not so much the traffic as the dogs: two affectionate spaniels who
begin the night with the daughters and end it with the parents. There
they lie, pinning your columnist under one-tenth of a duvet, until,
suddenly heeding the call of nature, they stir, stretch, leap off the
bed and tug her out the front door for an urgent visit to other parts.

In much the same way, volatility in financial markets is stirring from
the mat again. On Monday October 31st, British equities had their
biggest day in two-and-a-half years, rising by 2% thanks to some big
takeover bids. Across the water, the week of Ben Bernanke's nomination
to replace Alan Greenspan as head of the Federal Reserve saw a steepish
sell-off in bonds. The week before that, there was troubled trading in
equities as central bankers bombarded the public with inflation
warnings. In Japan, too, equity markets have moved relatively sharply
of late. So too in emerging Asia. 

Is all this just "noise"-- in response to specific bits of news, such
as better-than-expected personal-income figures or worse-than-expected
earnings at Amazon and Boeing? Have investors been treading warily
simply because it was October, a month haunted by the ghosts of crashes
past? Or is volatility definitely on the increase? And why does it
matter?

Volatility is the amount by which asset prices bounce about: the more
they bounce, the more uncertainty, or risk, there is. It is "the
probability of outlier outcomes", as Howard Simons, a strategist at
Bianco Research, puts it. One way to measure volatility is to look at
how prices have fluctuated historically--their "realised" volatility.
Spreads on credit-default swaps (insurance contracts against the
possibility that debtors will default) provide another indicator. The
most commonly followed measure, and one which often moves before the
other two, is the implied volatility in options contracts. Equities are
generally more volatile than bonds and currencies. And it is here that
volatility is stirring most noticeably now. 

The Chicago Board Options Exchange's Volatility Index (VIX) is based on
a basket of widely traded options on the S&P 500. The more turbulence
investors expect in the underlying shares, the more they are prepared
to pay for options. The VIX is nowhere near the 45 that it hit in
August of 2002 but, as the chart shows, it has been slowly rising since
mid-July. Germany's VDAX, an options contract on the DAX index's 30
companies, has been trending higher too.

Volatility is important for several reasons. Many reckon that it can
help to predict returns, though just how remains a subject of hot
debate. Much academic work suggests that markets tend to go down when
volatility goes sharply up, and vice versa. It doesn't always work that
way, though: during much of the 1990s, for example, both volatility and
stockmarkets rose. But higher volatility definitely favours certain
kinds of investors: it gives a fair wind to those who target volatility
as a strategy, and it offers more opportunities to those who hedge
their bets in other grand investment designs. (So why did hedge funds
have such a terrible October, by all accounts? Could it be that most of
them weren't actually hedged?)

More broadly, expected volatility has a lot to do with how attractive
financial assets are. It is the main parameter in pricing options, so
it determines the cost of insuring against uncertain outcomes. When
options are cheap, investors are happier to take the plunge in
financial markets. When they are expensive--ie, when it costs more to
hedge a bet--investors think twice. They tend to commit less capital to
"risky" investment and for shorter periods. 

So volatility has a bearing on economic growth, and rising uncertainty
is not good news for future output. It may seem strange to worry about
this now, when America's third-quarter GDP figures have just come in
stronger than expected, Britain's housing meltdown seems to be on hold
and Europe's company bosses are raiding their cash hoards to acquire
other businesses. But there are big question marks ahead. It is no
accident that the VIX, often called the "fear gauge", is rising. In
October, State Street's investor-confidence index hit its lowest since
its launch two years ago. 

Volatility was uncannily low until recently in large part because
inflation and interest rates were too. A tide of liquidity swept
through financial markets, exploiting anomalies, arbitraging
opportunities and dampening volatility. Long investors saw little need
to buy options against the chance that things might take a nasty turn
in this best of all possible worlds, while others were all too happy to
make a buck selling them. There was plenty of supply and not all that
much demand, so the VIX snoozed in the teens. 

Defter monetary management also played a role. Investors got used to
trusting central banks to keep the financial-market show on the road,
as they showed they could and would after the failure of Long-Term
Capital Management, a big hedge fund, in 1998 and the bursting of the
stockmarket bubble in 2000-01. And the Fed's new policy of giving
forward-looking statements on interest rates also soothed the markets:
since August 2003, the expected volatility of Treasury notes has fallen
by a third, on one measure.

GOODBYE TO ALL THAT
But low inflation, low interest rates and untroubled confidence in safe
hands at the helm are fast becoming things of the past. Oil-price hikes
have helped to push up inflation around the world. The Fed raised
short-term rates again on Tuesday, to 4%--its 12th quarter-point hike
since the middle of last year--and looks likely to do so at least once
more in the next three months. The European Central Bank may soon
follow its tough talk on inflation with some tough action. Japan is
more likely to raise rates than to cut them. Alex Ypsilanti, a
strategist at Merrill Lynch, points out that over the past ten years
the troughs in volatility have come one-and-a-half to two years after
the low points in three-month dollar LIBOR (interbank) rates. The Fed
started raising rates 16 months ago. 

Add to this equation a new Fed chairman, especially one who may tighten
just that bit too much in order to live down a reputation of being soft
on inflation, and increased volatility looks virtually assured. Indeed,
it could scarcely be otherwise. Looking into previous Fed handovers,
Goldman Sachs found that financial markets were more unsettled in the
first year than in almost all the rest of the new chairman's time in
office. 

And finally, while the outlook is not all bleak--far from it--there are
risks out there that neither central bankers nor financial markets nor
politicians know how to handle yet. These include huge global trade
imbalances and the shift in the balance of economic power that these
imply; the rapid proliferation of financial instruments (mainly credit
derivatives) whose valuation and ownership are not always clear; and
the rising indebtedness of households, particularly in America and
Britain. Given all that, it is hardly surprising that volatility is
stirring again. What is amazing is that it's not racing down the road
and barking.

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Read more Buttonwood columns at www.economist.com/buttonwood[1]

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