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The Hidden Danger in Low Volatility

The Hidden Danger in Low Volatility

Financial expert, Tim Lee explains how carry trading has shaped the global economic picture and the negative effect it has had on countries.

Stock markets around much of the world and asset prices in general are at, or close to, record high levels. Yet news reports are full of stories of political uncertainty or even instability, and concerns about economic recession. Hong Kong is a good, if perhaps extreme, example. Some news stories have talked about Hong Kong ‘imploding’ in the wake of political unrest. Yet sky-high property prices, which have tripled since the financial crisis, have barely faltered. The Hong Kong stock market is still over 40% higher than its lows of early 2016.

I lived in Hong Kong for the whole decade of the 1980s and saw three major crashes; one when the agreement over Hong Kong’s future was being negotiated in the early 1980s, one at the time of the global stock market crash in 1987 and one when the students were killed in Tiananmen Square in 1989. The Hong Kong stock market is down from its record highs now but the fall this time has not been on the scale of the 1980s, particularly when seen in relation to the previous rise.

Financially Hong Kong is an extreme example of a general phenomenon. In Germany there have been fears of recession and yet the German stock market is close to its record high. In Britain, there has been enormous angst about Brexit and yet, like Hong Kong, unprecedentedly high property prices have given back very little from decades of gains. In the US, the stock market climbs steadily higher through the impeachment hearings, trade wars and doubts about the economy.

There has been comparatively little discussion about this tendency of financial markets today to ignore economic and political developments. Some recognize a dangerous ‘complacency’. But most financial commentators seem to view financial market behavior as reasonable.

The truth is that this comparative lack of financial volatility is the result of misguided faith that the powers-that-be will prevent any significant decline in asset prices. I remember a conversation with a friend of mine, whose investment portfolio has done particularly well. I told him my view that at some point a major crash is inevitable. He said simply “they won’t let that happen”.

Who are ‘they’? The central banks mainly, but also governments. Paradoxically, the lesson people took from the global financial crisis is that central banks, who if necessary can print unlimited amounts of money, together with governments, have the will, the desire and the ‘tools’ to rescue the economy and financial markets, however bad things get. So for investors, in the event of a crash, just holding on will see losses recovered quickly. That has become the conventional wisdom.

The effect of this widespread belief and central banks’ actions has been to suppress financial volatility. In turn, this has made financial bets on volatility remaining low profitable, in itself further reinforcing the trend to low volatility. As Jamie Lee, Kevin Coldiron and I explain in our book The Rise of Carry, growing bets on volatility remaining low – what we call ‘carry trades’ – must be associated with growing levels of leverage and debt in the financial system and economy. Again paradoxically, this makes the whole financial system and economy more unstable even as it superficially appears more stable.

No one likes volatility and so there is very little complaint about low volatility. But volatility is an essential corollary of freedom. Freedom means volatility. To understand this, think of the counter-examples of the Soviet Union or communist East Germany. Life did not feature much volatility in these countries; not much changed from day to day – that is, until their regimes collapsed completely.

Today we can see the warning signs of instability bubbling under the surface. As we explain in The Rise of Carry, benefiting from low volatility really equates to benefiting from the status quo. In this situation, those who have the most resources, the most wealth, the best connections, win. Inequality relentlessly increases, and with it political instability and underlying economic instability.

In the book we show that in a world of suppressed volatility, major crashes are inevitable periodically. We point to the warning signs and what to look for financially. Unfortunately, it seems fairly clear that we will not have to wait too long for the next major financial and economic crash.

To read more from Tim Lee check out his new book, The Rise of Carry.
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The Hidden Danger in Low Volatility

Tim Lee has nearly four decades of experience in global asset management as an economist and strategist, having worked for asset management companies in Hong Kong and London and established his own economics consultancy, pi Economics, in Connecticut. His commentaries and analyses have been widely quoted.