Volatility and financial crises

I just finished teaching a course titled, ‘Advanced Quantitative and Economic Analysis’ for students of the Master of Science Programme in Applied Finance at the Singapore Management University, on Friday. I had talked to them in the last two sessions about how long periods of stability breed instability through the risk-taking channel. This is the hypothesis of Hyman Minsky.

I was pleasantly surprised to find a paper published by the Federal Reserve Board in October 2016 on this topic. The paper is:

Danielsson, Jon, Marcela Valenzuela, and Ilknur Zer (2016). “Learning from
History: Volatility and Financial Crises,” Finance and Economics Discussion Series
2016-093. Washington: Board of Governors of the Federal Reserve System,

While the common view is that volatility directly affects the probability of a crisis, this has proven difficult to verify empirically. In what we believe is the first study to do so, we find direct empirical evidence that the level of volatility is not a good indicator of a crisis, but that relatively high or low volatility is. Low volatility increases the probability a banking crisis, both high and low volatility matter for stock market crises, whereas volatility{in any form{does not seem to explain currency crises.

We further use the credit-to-GDP gap as a proxy for risk-taking, and find that low
volatility significantly increases risk-taking. This is very much in line with what theory predicts and provides strong evidence for Minsky’s instability hypothesis and his famous statement that \stability is destabilizing”. Low volatility induces risk-taking, which leads to riskier investments. When those turn sour, a crisis follows.

Finally, we find that the relationship between volatility gap and the incidence of a crisis becomes stronger over time, consistent with the observation that stock markets have grown in importance over the 211 year sample.

What they say on page 6 about stock markets, low volatility and crises is very interesting:

Third, since our 211-year sample contains a variety of economic systems, market structures, and technological developments, it is of interest to examine the volatility-crisis relationship over key sub-periods of the sample. The relationship between financial market volatility and the incidence of a crisis becomes stronger over time – not surprising considering that prior to World War I, stock markets, and hence market volatility, played a much smaller role in the economy than they would later. The relationship weakened again during the Bretton Woods era when financial markets and capital flows were heavily regulated, and became especially strong since.

The emphasis above is mine. The policy implications are obvious. We need to regulate capital flows. Keynes was dead right in that respect. That is why it was both surprising and disappointing that Vijay Kelkar and Ajay Shah, in their advice to the government on managing the aftermath of demonetisation, batted for capital account convertibility. Not only was it unrelated to the issue of demonetisation but it is also counter to the mounting evidence that it does not add to but subtracts from economic welfare.

Indeed, India should consider not only retaining the short-term transaction tax in financial markets but think of expanding its scope and enhancing the rate of such taxation!

Somethings do not add up

Doug Noland writes in his weekly credit bubble bulletin as follows:

Let’s return to election late-night. I doubt traders and the more sophisticated market operators will easily forget what almost transpired. It’s worth noting that while S&P500 futures and the Mexican peso were collapsing, the Japanese yen was in melt-up. In just over two hours, the dollar/yen moved from 105.47 to 101.22 – an almost 4% move. Meanwhile, EM and higher-yielding currencies were under intense selling pressure – the Brazilian real, South African rand, Turkish lira, Colombian peso, Australian dollar and New Zealand dollar (to name a few). At the same time, gold surged from $1,270 to $1,338. Crude sank 4%. Global markets were on the brink of a serious speculative de-leveraging episode. [Link]

Gold has sunk to USD1229 in the spot market by close of Friday. Japanese yen is back at 106.685. Stocks made new highs and held on to them on Friday. But, at the same time, EM stocks, currencies and bonds are hurting. Risk aversion is partial. U.S. stocks and dollar are exempt. So, there is a portfolio reallocation from EM assets, US bonds and gold to US stocks. I am not convinced it makes sense.

September snapshot

It was a month that marked the end of the quarter and hence, there was the inevitable end-of-quarter surge marked by rumours surrounding an eventual settlement between Deutsche Bank and the US Department of Justice. It was the month that the Federal Reserve threatened to act but eventually and unsurprisingly, didn’t. That allowed the S&P 500 to finish the month on a slightly positive note on a total return basis. The index was up 0.02%. That was a flat performance. Eurozone stocks were slightly better. They were up 0.67% during the month, in US dollar terms. Emerging market stocks turned in a reasonable performance with a total return of 1.32%. India lost 1% whereas Asia ex-Japan was much better with a return of 1.65%. China and Russia which had drawn closer politically were also strong stock market performers with gains of 2.55% and 3.87% respectively during the month. Despite the Bank of Japan appearing more confused, Japan stocks ended the month on a positive note with a total return of 1.32%.

Bonds – emerging or developed – had a relatively quiet month. However, commodities, oil in particular, had a strong month. Commodities (S&P Goldman Commodities Total Return Index) were up 4.1% while the West Texas Intermediate crude price gained 7.9% during the month, on the back of a supposed OPEC decision to freeze and reduce supply. The gains may be short-lived.

In short, it was a month that the cookie held up again and did not crumble. Therefore, the risk remains.


Brazil police wire-tapped a conversation between the current President and the former President! Wow!

Russia’s surprise announcement on troop withdrawal from Syria.

Martin Wolf quotes a non-Congress, non-BJP MP to suggest that the BJP government is above average. True. It could be exceptionally above average if bureaucrats do not run rings around their politician-bosses. Here is an example. The Cabotage liberalisation is not all that is cracked up to be.

China’s Premier says that it is impossible that China would fail to achieve 6.5% growth this year. You too can now forecast China GDP growth.

Wall Street Journal has a good Edit on the Premier’s assertion calling it ‘whistling in the dark’. The short anecdote about Heilongjiang Province’s Governor Lu Hao’s bold assertion that proved wrong is very insightful.

South Africa raises interest rates amidst political tensions. RBSA seems like an oasis of calm, tranquility and competence. Sounds like India in troubled times.


Weekend links – 12.12.2015

Disappointing remarks by Shashi Tharoor on cows being safer than Muslims cleverly attributed to an unnamed Bangladeshi.

Minhaz Merchant has a thoughtful piece. I think what he alludes to on the attitudes of the leadership may be happening already.

A lady recounts her experience with Chennai rains and floods. Anil Padmanabhan has another good column on India’s urban planning or the lack of it. Zeroing in on the failure on the ‘Disaster Management’ front in Chennai.

Journalist cum auditor cum Hindu scholar Gurumurthy explains the ‘National Herald’ case in a series of tweets.

Good to know that India’s BPO policy for small towns attracts a lot of interest.

Good to read the former Foreign Secretary explain the dangerous games being played by the Nepali ruling elite.

ISRO to launch six Singapore satellites on 16th December.

Hong Kong may have a message for the beef bhakts in India.

The Sports Bubble is about to pop. 2016 will truly be the year of discontinuity.

This line caught my eye:

For more than 30 years prior, ESPN enjoyed an unbroken stream of growth and innovation on its way to becoming the immovable Gibraltar of the cable bundle. [Link]

Apparently, UBS did not feel energized by a visit to China. The economy is still struggling. Torrent of Commodities exports from China. Protectionism will be catching up soon.

We can keep writing about the imperative of reforms and restructuring in China. But, China is not interested except to pay lip service. China’s room for fiscal manoeuvre is limited. I agree. The China horror story from shipping industry woes

In China, the plot always continues to thicken. An ally of the deposed former princeling Bo Xilai died mysteriously in a heart attack in prison. He was only 44. The FT story has more meat in it. He had testified against Bo Xilai’s wife. The prosecutor who had helped put Bo Xilai’s wife had died under mysterious circumstances too earlier in the year.

The US is to deploy P-8 Poseidon surveillance aircraft to Singapore for the first time in the latest response to China and its growing military presence in the South China Sea. China is paying close attention.

Knife attack in London Tube Station on Saturday evening. Police treating the case as an act of terror.

Edward Luce writes that America more polarized than before after San Bernardino massacre when a Muslim couple casually shot 14 people dead, after leaving their baby with their mother. The husband was earning $70K in his job.

LA Times story on the San Bernardino shooters.

Short on answer but long on diagnosis. Interesting, important and useful read, nonetheless: “there are no quick fixes to the problems of urban disenchantment”. If so, are there no quick fixes to reversing the appeal of violent jihad?

French regional elections go into the second and final round over the weekend. It could signal tectonics shift in country’s politics. To that extent that it polarised the country’s politics, it will be a victory for ISIL.

In Germany, the number of registered asylum seekers rose to about 965,000 by the end of November, exceeding the government’s full-year forecast from August of 800,000.

Petition in the UK gathers more than 200,000 signatures for banning Donald Trump from entering the UK for his call to ban Muslims from entering the US for a year. The choice of the picture of Trump accompanying the article is revealing.

Two very good reads on Donald Trump and what he means for the broader discourse.

Turkey PM says Russia doing ethnic cleansing.

Did not know that Finland is debating a motion on staying in the Eurozone. Wolfgang Muenchau thinks that Europe may have to disintegrate before reintegrating.

Turkey angered by a Russian solider displaying a rocket launcher on shoulder as Russian ship passed through Istanbul.

According to this FT report, BIS still wants Western Central banks to normalize monetary policy without being swayed by financial market volatility (December BIS Quarterly Review).

One among many reasons why ECB did not offer as much stimulus as the market expected:

A pending U.S. Federal Reserve rate hike also factored into the decision, though to a lesser extent, as policymakers were concerned that a big move by the ECB would weaken the euro further and possibly force the Fed to delay its own action on rates to prevent a too rapid divergence of policy between the world’s top two central banks. [Link]

ECB Governing Council member Ewald Nowotny called market expectations of a big ECB move absurd. He was probably addressing ECB President stoking the market expectations as well.

SEC to crack down on derivatives. About time too.

Larry Summers endorses India’s stance at COP21. India’s rich have a smaller carbon footprint than rich countries’ poor. Very interesting.

Scientists link UK weekend storm to man-made global warming

Sanjeev Sanyal explains why Delhi’s road-rationing policy (odd and even numbered plates) might be difficult to implement.

China issues red alert for pollution in Beijing. What about Delhi? Further, the Public unhappy with China government for failing to issue pollution red alert in Beijing.

Saudi Arabia is getting isolated in many ways, it seems. Its stance in the Global Climate Negotiations comes under critical scrutiny.

Gideon Rachman in FT: Perhaps it is time to give the Saudis a choice: agree to allow churches, Hindu temples and synagogues to open in Saudi Arabia, or face the end of Saudi funding for mosques in the west.

Iranian leader Ayatollah Khomeini’s grandson to enter politics. He is considered a moderate.

It is not clear what exactly are hedge funds hedging. They have had a rough year. The real shakeout in the industry is still in the future.

FT thinks that South Africa removing its Finance Minister from his job was a bad idea.

FT has a long story on America’s shrinking middle class. If a distribution of any phenomenon is shrinking in the middle and fattening in the tails, it is no longer a normal distribution but a skewed one.

Capital flowing out of Turkey too and not just out of China. Well deserved, I must add.

Sovereign wealth funds pulling money out of asset managers.

Moody’s puts Brazil credit rating for a review for possible downgrade to junk status. Must be in the price already. Currency hardly reacted.

The shrinking Gross Planetary GDP – fascinating.

South Korea to issue a ‘panda’ bond (bonds denominated in RMB)

The head of the Croatian Human Rights Group sees his pants drop while posing for a picture with Croatian woman President!

On genetics and fitness. Looks like it does not make sense to exercise outside at all, in places like Delhi.

Andrew Batson’s list of best books he has read for 2015

Lest I forget – Reading Links

Moody’s downgraded France’ credit rating from Aa2 to Aa1.

S&P downgraded Japan two days earlier on September 16

Japan’s Parliament approved overseas military expansion

Indonesia decided to abandon its high-speed rail project. Sensible decision. Something for India to think about.

Oops! I wrote that last one too early. It is back on track!

Is Saudi Arabian Sovereign Wealth Fund history? Curtailment of Saudi finances for overseas causes (hint, hint) cannot be bad news at all.

Widening bond spreads cannot be good news for the economy and for stocks in the US; if so, for stocks everywhere. Junk bond yields crossed 8% in the U.S.

China’s industrial profits declined 8.8% y/y in August. Biggest since 2011. Not news to me. News is that they had a stock bubble going without any support from corporate bottomline.

Deutsche Bank reports that liquidity in currency trades is drying up. Not good news either.

The dark side of globalisation – weaponisation of everything.

Harvard Endowment’s Annual Report for 2015 warns of potentially frothy conditions in illiquid markets.

Janet Yellen, Fed Chairpeson, went to my Alma Mater, the University of Massachusetts, Amherst, and warned that rates cannot go much below zero (?!). Also, said that keeping rates for too long below zero could endanger financial stability. Too late. The horse fled the barn a while ago.

The Chicago Fed National Activity Index fell very sharply in August. What gives?

Labour vs. Capital. Time for the pendulum to swing in the other direction? We are going to hear a lot more of this in coming years.

Finally, the haze in Singapore shows no signs of leaving.

Growth payback

Crude oil price (WTI) dipped below 40 on August 24. It closed at around 47 on Aug. 31 – 25% jump in a week. But, that is to be expected. Extreme movements and extreme reactions – more noise and less substance. Short-term noise is all that financial markets of today generate. Long-term trend seems down. Simple reason: global economies gorged on credit and fast forwarded growth. Nothing left in the tank now. Period.  All other arguments are circular and endogenous. For example, this one:

One of the main dynamics behind the downdraught is world trade. [Link]

The authors quickly clarify:

At least part of the reason behind the waning trade performance is a vicious circle of cause and effect. [Link – could be behind firewall]

An India Market Strategy report by Credit Suisse has an interesting fact:

Oil exporters with burgeoning surpluses ended up creating SWFs, which allocated funds by formula, and several were also heavy users of ETFs. As almost all now run high deficits, they are forced to sell their holdings to fund their government, and also to maintain the USD peg.

This is showing up in capital flows not just slowing but possibly reversing, as the combined current accounts of oil producers may go from a surplus of US$407 bn in CY14 to a deficit of $106 bn if US$45/bbl sustains.

My guess is that it would sustain and even dip. The world, by and large, remains in denial about the growth payback consequence of fast-forwarding of future growth through leverage, in the new millennium.

The FT article linked above has good charts. It ends with the usual homilies about reforms that are needed in emerging economies. Might as well be said in the context of developed nations too. But, the recognition and acceptance of low growth as a consequence of past debt excesses is yet to be formally recognised.

Coming out of addiction to recovery is not straight. The intermediary step – de-addiction – is often the most painful. But, there is no skipping it. Attempt to ignore, sidestep and worse tackle it with more liquor (debt) is worse. There is no recovery at all, then.