Measures of economic uncertainty help investors to track popular fear or complacency for the purpose of trading strategies. Academic papers propose various methods: keyword frequencies in news, equity market volatility, earnings forecast dispersion and economic forecast disagreements. Composite measures suggest that uncertainty typically rises abruptly but declines just gradually.
A long-term empirical study finds two fundamental links between market volatility and financial crises. First, protracted low price volatility leads to a build-up of leverage and risk, making the financial system vulnerable in the medium term (Minsky hypothesis). Second, above-trend volatility indicates (and causes) high uncertainty, impairing investment decisions and raising the near-term crisis risk.
A two-decade empirical study shows that bond and equity market prices are more likely to “jump” on days with U.S. economic data releases. In particular, surprises in news announcements tend to lead to higher volatility and larger price moves. The impact of key data surprises on bond markets seems clearer and simpler. The impact on equity markets depends on the state of the business cycle
An ECB working paper explains formally why senior decision makers are unprepared for crises: they can only process limited quantities of information and rationally pay attention to rare events only if losses from unpreparedness seem more than inversely proportionate to their rarity. The less probable a negative event, the higher the condoned loss. Inattention gets worse when managers bear only limited liability.
A new BIS paper provides evidence that since 2013 fluctuations in EM fund flows and EM bond prices have reinforced each other. Both redemptions and discretionary sales of fund managers have been pro-cyclical. In liquidity-constrained markets this behavior is prone to transmitting shocks and amplifying crises.
A recent speech by Fed governor Jerome Powell highlights recurrent episodes of short-term distress and vanishing liquidity in large developed markets. Increases in trading speed, market concentration, and regulatory costs of market making all may be contributing to these liquidity events.
There is evidence for a double relation between volatility and returns in equity markets. Longer-term fluctuations of volatility mostly reflect risk premiums and hence establish a positive relation to returns. Short-term swings in volatility often indicate news effects and shocks to leverage, causing to a negative volatility-return relation. Distinguishing the two is important for using volatility as a predictor of returns.
Financial markets often disregard the fundamental difference between volatility (the magnitude of price fluctuations) and risk (the probability and scope of permanent losses). Standard risk management and academic models rely upon volatility alone. Alas, this reliance can induce an illusion of predictability and excessive risk taking. Indeed, low volatility can indicate and even aggravate the risk of outsized permanent losses.
Over the past 25 years the relation between implied equity volatility (VIX) and market returns has been non-linear. When VIX was low there was no meaningful relation. However, when volatility increased above average higher equity and lower bond returns followed. This is evidence for “flight to quality“, where investors pay a rising premium for safe and liquid assets as volatility increases. Fear of redemptions, liquidity constraints, and deteriorating market intermediation are plausible causes of this effect.
Variance risk premiums mark the difference between implied (future) and past volatility. They indicate changes in risk aversion or uncertainty. As these changes may differ or have different implications across countries, they may cause FX overshooting and payback. The effect complements the simpler argument that rising currency volatility predicts lower FX carry returns. Academic papers support both effects empirically.
Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.
