Sunday, September 14, 2014

Low volatility is a sign of high risk-taking, BIS official says

By Steve Goldstein

WASHINGTON (MarketWatch) — Low volatility and compressed risk spreads are signs of high risk-taking, a Bank for International Settlements official said as part of the group’s quarterly review.

The BIS is often referred to as a central bank for central banks, and it’s been warning for years of the dangers of very low interest rates.

The chart above shows the implied volatility of the S&P 500, Euro Stoxx 50, FTSE 100 and Nikkei 225, weighed by market cap.

“A common mistake is to take unusually low volatility and risk spreads as a sign of low risk when, in fact, they are a sign of high risk-taking,” said Claudio Borio, head of the monetary and economic department at the BIS.

“It all looks rather familiar. The dance continues until the music eventually stops. And the longer the music plays and the louder it gets, the more deafening is the silence that follows.”

Borio told reporters that volatility is low because of “muted uncertainty” about the economic outlook and unusually accommodative monetary policy. “People may not necessarily like what they see, but they seem to think they see it more clearly,” he said. Borio added that the last time uncertainty was this low was in 2007 — just before one of the largest forecast errors the economics profession has ever made.

Debt issuance has picked up markedly from companies headquartered in emerging market countries, the BIS notes.

Hyun Shin, an economic adviser and head of research at the BIS, says there’s good and bad in that development.

“On the one hand, developing countries have large capital needs, so mobilizing the savings of the rich countries to harness these opportunities is clearly welcome,” he said. But leverage also has increased significantly.

Emerging-market companies also have extended the maturity of their obligations.

“Yes, the share of debt to be refinanced every year has fallen, but longer maturities make fixed rate bonds more sensitive to interest rate movements, which makes them riskier for investors,” he said.

There’s evidence of “herding” by asset managers in asset markets. Widespread benchmarking and short-term performance assessment limit the willingness of portfolio managers to depart from the norm.

During last year’s taper tantrum, retail investors withdrew from funds when prices were falling and re-entered when prices were rising. That forced funds to do much the same.

The BIS took a look at house prices across several countries. Based on comparing prices to income and rent, Canada could see a reversal or a slowing in growth, and Belgium and France could see a further deterioration.

At 17%, the U.S. is near the top in terms of real house price growth over the last three years. Spain, by contrast, has seen a 21.5% slide.

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