Is there a paradox of low market volatility?

The FT reports:

Wall Street’s “fear gauge” has fallen to a seven-year low, helping propel US stocks to a record peak but suggesting investor complacency reigns over financial markets.

The CBOE Vix equity volatility index, a barometer of investor sentiment, slipped below 11 on Friday, nearly half the long-term average and its lowest level since February 2007. The Vix has fallen in recent years in conjunction with a robust recovery in equity prices from crisis levels as central banks pumped money into the financial system.

Now, it seems the Fed would be less afraid if it saw investors being more afraid, or at least that is the new conventional wisdom.  That is a coherent view if the Fed knows that it doesn’t know what it is doing with the unwind of the taper and the like.  The Fed has private information that things may be screwy, but private investors don’t have that same information.  The Fed then thinks that investors might thus be overextending themselves and then the Fed gets worried all the more.

But is that, taken alone, a coherent equilibrium of beliefs?  Not yet, because it seems someone’s beliefs should have to budge.

So how does all this hang together?  The Fed doesn’t want to crush the market, it just wants to test whether investors might in fact have some private information of their own.  By “leaking” that it is worried about low volatility in the market, the Fed can see whether investors suddenly panic or whether they have a relatively firm basis for not feeling so worried.

And so far investors have not panicked, quite the contrary.  The relatively sanguine beliefs of private investors thus seem to have a fair amount of depth.  The Fed has nudged investors, to learn something about the shape of the response curve, and those investors have held their place or warmed to the data all the more.

So if you believe in rational actor models (a big if, admittedly), you should be bullish about asset prices looking forward.  Maybe about the real economy too.  We’re seeing lots of good numbers about credit for the United States and that is a significant leading indicator.


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