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Fear subsides, prices rise





The Vix index (implied equity volatility) has fallen to its lowest level since the onset of the panic selloff in equities which began last May (which in turn was driven by the belief that the economy was on the cusp of a double-dip recession). Equities have not completely recovered from that episode, however, but they look to be in the process of doing so, and a declining level of fear is one important driver of the rally. As the top chart shows, the implied volatility of T-bonds, as measured by the MOVE index, fell dramatically this week. This is also helping equities, and let me explain why.

It would appear that the market has reached an almost unanimous opinion that the Fed will implement a second round of quantitative easing early next month, this time with the objective being to pull down 10-yr Treasury yields and keep them down for a considerable period. I think this is foolish and unnecessary, as I argued in yesterday's post, but those concerns are irrelevant for now. If one believes that the Fed will do all in its power to suppress 10-yr Treasury yields in an effort to avoid deflation and to spur the economy, then it makes sense that the implied volatility of Treasury options should fall to very low levels. After all, isn't the Fed going to practically guarantee that yields won't rise? And since they can't fall a whole lot more than they already have, this means that we are now (supposedly) at the beginning of a long period of low and stable yields (though I'm not necessarily agreeing with this). So options become very cheap, because uncertainty has all but vanished.

As I argued yesterday, the important thing about the Fed's promise to do anything it takes to avoid deflation (and maybe even to push inflation up) is that this all but eliminates the risk of deflation if done in convincing fashion. Deflation fears have been lingering for quite some time now, but now they are vanishing. When you take deflation risk off the table, suddenly the expected future value of all cash flows goes up: that's why the stock market is going up.

At this point it is probably not even necessary for the Fed to proceed with QE2. Promising in convincing fashion that they would do it if necessary is enough. And the market is now convinced. That automatically brightens the future, even though it leaves alive the concern that they will push inflation too high.

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