It wasn't supposed to be this way when our good friends at the Federal Reserve blew the whistle to signal the end of quantitative easing and the impending rise in short-term interest rates. We certainly had some price volatility in May-June 2013 and again in January 2014, but the first episode was squelched by Federal Open Market Committee officials running around the landscape assuring everyone that they didn't mean to be so upsetting. The second episode fizzled out when a series of interest-rate increases in emerging markets ended the unwinding of dollar and especially of yen carry trades.
Consider the absurdity of it all: We're in the process of pulling the curtain back on a mountain of bad debt in China; Vladimir Putin is trying to put the band back together in the former Soviet Union; the eurozone is dancing on the edge of deflation; and the US is going to end QE and start raising short-term interest rates, not on the basis of any scientific rules but rather on the basis of "If it feels right, do it" -- and yet markets are tranquil.
The decline in realized volatility can be illustrated simply enough by taking the rolling three-month average of 30-day volatility as it compares to the May 2003-May 2004 one-year period. The results are displayed on a common logarithmic scale. I used the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), the iShares Barclays 7-10 Year Treasury Bond (NYSEARCA:IEF), the iShares MSCI EAFE Index Fund ETF (NYSEARCA:EFA), and spot market prices for gold, crude oil, and the euro.
All seven markets' volatility ratios are below the 2003-2004 window; only the EFA's measure is trending higher at the moment. I could add ranges for measures such as the shape of the yield curve or 10-year TIPS breakevens, but you get the point: Markets are moving sideways.
Markets used to be traded by real people, some of them admirable and some not, but all were involved in trying to make their counterparts' lives miserable. They actually served some socially useful functions in so doing, not the least of which was pushing markets to identifiable support and resistance levels and seeing whether long-term players came in to buy the lows or sell the highs. Floor traders and specialists contributed to this misanthropic venture by running stops to shake out the short-term players. All of that activity generated publicly visible price signals telling producers and consumers where the price bounds were.
More importantly, slow execution times and high execution costs forced traders to focus on economic signals and prices trends as opposed to the noise created by a stream of low-cost orders coming in at a high frequency. These longer-term positions had to be established with some measure of knowledge about the market involved, and that took time and effort.
High-frequency trading (HFT) can be done in the absence of fundamental information or even technical analysis as it was known and practiced forever. It can exist in a Brownian motion vacuum of no signal and a lot of noise; indeed, I have suggested that HFT practitioners could be just as happy plying their craft using a stream of random numbers and gouging each other's eyes out in a true zero-sum fashion. Outside traders could be allowed into the party, but why would they want to go there?
The HFT world can and does produce a huge volume of activity, and that makes the exchanges and suppliers to the industry very happy. If they're happy, I'm happy. At the end of the day, though, all of this activity can produce gains and losses but very little economic information as a waste product. This is a loss to society, one that doesn't get addressed enough. Between central planners masquerading as central bankers and HFT activity going on without producing economic signals, markets aren't producing the signals necessary for risk assessment and the efficient allocation of resources.
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