By James Saft
(Reuters) - The VIX, the so-called fear gauge, is dead but the real risk-appetite index is falling.
The dollar is the new and true North Star of global markets, according to a study released on Tuesday by the Bank for International Settlements, with a rising dollar coinciding with falling risk tolerance.
This just in time for the Trump era, widely expected to bring with it rising inflation and interest rates driving a rising dollar.
With the advent of quantitative easing and other extraordinary monetary policy in the aftermath of 2008, the old relationship between the VIX index of implied volatility in equity markets and banks’ willingness to use leverage broke down. As investors use borrowed money to add risk, having a measure of how much they were laying on was crucial. Indeed, despite the VIX remaining at historically low levels, borrowing by capital market banks has fallen, in part also perhaps because of new and tighter regulation.
Over the same period, analysts have been puzzled by the fact that people wanting to borrow dollars in foreign exchange markets have paid above-market interest rates, something which should be “impossible” if only there are people with money willing to step in and arbitrage this risk-free gap.
So whereas a decade ago you could look at the VIX and see risk appetite in a single price, now the relationship is better expressed by the value of the dollar, which tracks banks’ willingness to use their capital to arbitrage gaps in forex market interest rates.
“Just as the VIX index was a good summary measure of the price of balance sheet before the crisis, so the dollar has become a good measure of the price of balance sheet after the crisis,” BIS Head of Research Hyun Song Shin, one of the authors of the study, said in a speech on Tuesday.
“The mantle of the barometer of risk appetite and leverage has slipped from the VIX, and has passed to the dollar.”
(http://www.bis.org/publ/work592.pdf)
And the important point is that cross-border lending falls as the dollar gets stronger. Shin theorizes that this is because so many global institutions have high dollar liabilities, often because they’ve sought higher-yielding paper denominated in dollars. The more the dollar rises, the more painful this “naked currency mismatch” becomes. To compensate, they cut back on the use of leverage.
TRADE SLOWDOWN EXPLAINED?
All of this may help to explain yet another puzzle; the sub-par growth in global trade.
One of the huge changes in the global economy over the past two decades is the growth of complex and far-flung value chains, set-ups in which goods are manufactured in varying stages all over the world.
While this does a good job of taking advantage of lower wages in places like Asia, it is highly dependent on dollar financing being available to fund the exchange of first a raw material from where it is produced to where it will go into an auto part, for example, and then on to where the parts are assembled.
As the dollar has strengthened since 2014, global trade growth has slowed, actually turning negative in Asia outside China. We don’t know for sure, but a higher cost of dollar financing as the dollar rises may be acting as sand in the wheels of global trade.
This brings us round to President-elect Trump and the strong dollar. The trade-weighted dollar index has risen rapidly since the election, hitting its highest level on Wednesday since April of 2003, a time, ironically, when U.S. and allied forces were “mopping up” after the second Iraq War.
The simple explanation for why the dollar is going up in anticipation of the Trump administration is that he’ll engineer a stimulus which will drive demand, and with it inflation. This will prompt, or allow if you prefer, the Federal Reserve to tighten interest rates more quickly than they otherwise would.
Fed fund futures are assigning a 90 percent chance to a 25-basis-point hike by the Fed at its policy meeting concluding Dec. 14.
Higher yields at the short end will drive up yields at the longer end, something we’ve already seen to a remarkable degree, and in lower-quality bonds too. This will attract more investors to the dollar and dollar-denominated securities, driving up its value. A stronger dollar could thus not just reflect stronger activity in the U.S., but also slow trade and activity elsewhere as banks become less willing to use or provide leverage.
If the Federal Reserve is able to normalize, the old relationship between volatility and risk appetite may come back.
A stronger dollar may be in someone’s interest, but it is hard to work out who, exactly, that would be.