The Fed can’t cure the chaos

The economic crises of the last decade made linear thinking about the economy very unhelpful. But our previous planning failures do not relieve us of the need for more analysis now. But if the economy is not linear what are our choices because simple curves, like the yield curve, don’t provide much information either?

We are left with employing some version of chaos theory. If we accept, as we should, that the markets are hypersensitive to small perturbations, operate in a nonlinear fashion, and have disproportionate cause and effect outcomes, then we should also accept that we are in a chaotic situation.

Measuring the degree of chaos is a highly technical matter and well beyond the scope of this note. We can, however, get some measures of the market’s price for the chaos without delving into things like fractal dimensions.

VIX Index

As a practical matter we can start with the usual risk measures like the VIX index. The VIX is produced by the Cboe Options Exchange® using SPX options which expire with more than 23 days and less than 37 days. These are weighted to a constant maturity 30-day measure. Essentially the implied volatility in these contracts gives a measure of the market’s price of risk.

It is instructive to see that the peak in the VIX going back to 1990 happened only two years ago in 2020. We can easily explain this as the pandemic’s effect, but a great many things occurred before then including the attack on the World Trade Center, wars, and the Great Recession, to name a few.

The current level of about 30 is well off of the VIX’s all-time highs but still at the upper end of its recent trading range. The VIX signal of continuing volatility seems justified. Afterall, we are close to a US election and highly likely headed into a cold European winter. In addition, many macro issues are still on overdrive i.e., a European war with no end in sight.

Bond OAS

Another risk related index, the ICE BofA BBB US Corporate Index Option-Adjusted Spread (BBB OAS), provides less dramatic variations in measuring market risk. The index shows the spread of the BBB corporate bond yields to US treasuries, after adjusting for any option values. The current level of the index is about 200 basis points. While elevated from recent month levels, it is far off of its all-time high of about 780 basis points in 2008.

The difference in the behavior of the VIX and BBB OAS index suggests that the concerns of the market about risk may be more technical than fundamental. That is, variable corporate earnings resulting from supply chain issues and market liquidity factors are more of a concern than the solvency of companies. In a sense, this is good.

Profitability and liquidity

Unfortunately, we have seen that profitability and market liquidity, can be critical to well-functioning markets in periods of economic stress. The OAS Index should not be expected to continue to be well behaved if the VIX repeats its prior highs. Market technicals and fundamentals can be closely related at times of stress. And we expect periods of stress in the future.

Reassess investor risk tolerance

The Fed, meanwhile, is rudderless. The failure of the Fed to offer a model-based policy directive is among the driving forces for the need to rely on market-based volatility pricing.

For the investor, there is little to suggest a significant fall in market risk. Still, the resilience of the economy has been demonstrated repeatedly this year. But, even if the market remains resilient, investor risk tolerance is likely to decrease. Investors need to resist the urge to flee the market as long as liquidity is adequate as it is now. However, future volatility may well demand more liquidity.

Investor implications

1. Stay invested and expect the market to settle down eventually.

2. Maintain enough liquidity to cover near term problems.

3. Do not expect consistent behavior from the Fed.

This article is not intended as investment, tax, or financial advice. Contact a licensed professional for advice concerning any specific situation.