Part of my article below actually appeared in the Hindu Business
Line Link a
few days back, made some additions to the original post
and re-posting it.
Even after two
decades when it was decisively established that the forces of invisible hand
are far superior to the command and control structure in bringing about the
economic growth and prosperity, the Central Bankers across the world have not
stopped trying. Perhaps the human urge for power and to feel that he is in
control of his surroundings may also be playing a part; the belief that they
have the might and the power to control the business cycles and to do away with
recessions is evident in the dramatic increase in their interventions in the
asset markets this past decade and now with the global economy in a flux ever
since the financial crisis of 2008 it has increased further. Like the financial
derivatives, the asset classes (equity, commodity, fx, bonds and real estate)
are derivatives on the real economy and hence their price action is just a
forward looking reflection of the economic condition. Thus a high volatility in
any one of these asset classes can be a harbinger of the perilous state of the
economy and so ever since bouncing off the abyss in 2008-09 the Central Bankers
and Planners try to control the behaviour of the asset class that starts to
exhibit high volatility.
With years of
intervention we have reached at a crossroad where the Central Banks have
completely lost their control over the only component of the asset market where
they actually had one; “the yield curve”. This became apparent in the late 90s
in Japan and then finally here in US, when the Fed after propping up the
property market in lieu of the busted Nasdaq bubble tried to control the
elephant from turning into a dinasour by increasing the Fed Funds Rate in June
2004, however it soon found that it has completely lost control over the yield
curve as the graph below demonstrates:
Chart a
So from June
2004 to August 2005 the Fed funds rate increased from 1% to 3.75% however the
10 year yield was at best flat; result - the property boom couldn’t be slowed
down and the elephant actually grew bigger leading to the ofcourse eventual
dramtic collapse. So as is apparent from the graph above, the Fed lost control
of the yield curve almost 6-7 years ago however even now the Central Banks are
living in a cinderlla world as is apparent by the announcement of “Operation
Twist”.
The recent
announcement of the Swiss Central bank to peg the Swiss Franc against the euro
shows how this contagian to control the asset markets is spreading like a wildfire
and in turn leading to a mispricing of assets and thus aggravating the economic
situation. Let me elaborate further by picking on this example, so to maintain
this peg the Swiss Central Bank would have to print as many CHF as it would
take. Now because of the peg the volatility in the CHF-EUR currency market
would diminish however the question that one should ask is what would one do of
the new swiss francs that have been created, well using that the market
participants would buy more of bonds/stocks/commodities etc. and thus what
happens is that volatility would spill over and add to the existing
volatilities in other markets, in
essence volatility is not destroyed, just transferred.
To
establish how the volatility from this currency pair has moved into the other
asset classes, below are the charts of standard deviation (volatility in simple
words) of the daily changes in the CHF-EUR currency pair pre and post the
announcement of the peg and a similar chart for the equity pair of the
Swiss Stock Index to the French Stock Index i.e the (SMI/CAC
ratio) for the same two periods. Please note that in order to have a
similar comparison with a "currency pair" it's important to pair the Swiss
market with a major Euro market as this would remove the effects of the
volatility due to the broad common macro moves thus bringing about clearly the
volatility impact due to the currency peg, also I am excluding the market data
on the announcement day as we are interested in what happens "pre"
and "post" peg announcements.
Chart b
Chart c
A brief
glance at these charts would tell you that even though the Swiss Central
Bank was succesful in reducing the volatility of the CHF-EUR currency pair, however
the unforseen impact of their action has been that part of the currency
market volatility has moved into the Swiss stock market as exhibited by
the volaitlity of the SMI/CAC ratio which has almost doubled post currency peg
announcement
All this shows
the ineffectiveness of the actions of the Central Banks as not only the
volatility from one asset class moves to the other asset class thereby keeping
the overall volatility in the system as same but excess of control would mean
the volatility entering into the broad economy which is precisely what they
intended to control to start with and so instead of taking the signal from the
asset class exhibiting high volatility their actions leads to a mispricing of
assets and thus aggravating the economic situation.
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