Volatility Meets Liquidity
We have seen a rise in volatility over the past week just as a growing chorus of voices began lamenting the lack of price movements across asset classes. Investors appeared comfortable waiting for the growth and reform initiatives to emerge from the Administration, which formed the basis for the relatively large move in asset values since the elections. The apparent longer ramp for the most market significant initiatives, fiscal stimulus, tax reform and deregulation by our account, did not create much angst as shown by a VIX that remained near its all-time lows at the start of the month. A Fed rate hike also did little to shake the trend, with the broad commentary of a dovish hike mitigating much of the concern. More recently, investors have been faced with greater geopolitical concerns in Syria and North Korea, along with greater fluidity in the polls leading up to the French election. However, since we attribute much of collapse in volatility over the past 5+ years to the massive pools of liquidity created by central bank balance sheets, the continued growth of this liquidity may once again contain any vol spikes. From this vantage point, the apparent desire of the Fed to begin reducing the size of its balance sheet by the end of the year certainly bears watching Additionally, Fed balance sheet reductions in 2018 may coincide with a less active ECB, which is increasingly stretched in its commentary that the Eurozone continues to need extraordinary measures to fight off deflation. There is therefore a distinct possibility that next year we will begin to see a sustained reduction in overall central bank balance sheets for the first time since the crisis. The chart below shows that while there have been periods of balance sheet shrinkage, the overall trend has been upward sloping since the crisis, with total assets currently exceeding $13 trillion despite the Fed just maintaining its asset levels for the past two years. Until then however, that liquidity remains in place and has acted as a shock absorber for many market moves over the past year.