Bank of America Stumbles On A $51 Trillion Problem

Of course, central banks are all too aware of the risk that this record debt stock presents, and specifically, the threat of sudden, damaging spikes in interest rates cascading into overall volatility surges, which explains why, as BofA puts it, "central banks have been sellers of vol" through QE. Quote Martin:

QE programs around the globe have had a clear target: to reduce uncertainty and dampen market volatility. As we have highlighted before, every time the Fed embarked on the different phases of its QE programme, credit implied vols declined significantly (chart 6). On the other hand, during periods of no monetary easing or when the market started pricing the possibility of easing policy removal (tapering tantrum and the subsequent tapering phase) implied vols advanced (chart 6). Same happened in the case of the ECB: implied vols have re-priced lower post the announcements of the PSPP and the CSPP.



However, when both the Fed and the ECB attempted to communicate that these policies will have an end-date, implied vols repriced significantly higher. A good example is the market reaction post the May 2013 Bernanke’s mention of the idea of gradually reducing the Fed’s monetary expansion. The same reaction was seen back in October last year, when tapering fears hit Europe: implied vols moved higher over the  following couple of months.

So on one hand there is the threat of central bank balance sheet normalization which may, at any moment, prompt a violent repricing of volatility. On the other, Barnaby writes that "our work shows that the majority of vol spikes over the past years have taken place during periods of geopolitical uncertainty. Since 2013 we have seen a number of vol spikes and most of them had been the result of rising geopolitical risk."

In 2013 it was the Syrian crisis and in 2014 was the Russia–Ukraine conflict. In late 2015 it was the Paris terrorist attacks and in middle last year it was the UK referendum. Recently we find that rising risks on the Korean peninsula has pushed spreads and vols higher. Note that European credit spreads have been in a constant tightening momentum since the CSPP announcement in March last year, but have moved wider in the past month or so.

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