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Economist Insights 20130114

Economist Insights 20130114

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Published by: buyanalystlondon on Jan 14, 2013
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Economist Insights
 Risky habits
14 January 2013Asset managementBreaking news: the Eurozone single currency is at risk ofbreaking up! More breaking news: the US is dangerouslyclose to a self-inflicted default! Yet more breaking news:China’s economy has been slowing down!If none of this ‘news’ came as a shock to you then welcometo the phenomenon of
. The more thatpeople are exposed to a risk, the less risky that risk isperceived to be. When investors first heard each of thosenews items, there was a sharp market reaction. None of theproblems have gone away, and in some cases (particularlythe US) the risks have arguably increased. Yet familiarity hasbred contempt, and what scared markets before does notscare them anymore.The traditional benchmark for volatility is the VIX index,which measures the implied volatility of S&P 500 indexoptions. When investors become worried or uncertainthey tend to buy options to protect themselves, so optionsbecome more volatile and the VIX rises. Unsurprisingly, thebiggest spike in the VIX index occurred in 2008 followingthe collapse of Lehman Brothers (see chart 1). Since thenwe have seen several spikes, most notably in 2010 as theEurozone debt crisis escalated and then again in 2011 as theUS had its first debt ceiling debate. Ever since then, volatilityhas remained incredibly low – pretty much at pre-crisis levels.This is despite huge fluctuations in the policy risks.A novel way of measuring the risks is the “policy uncertaintyindex”
(also shown in chart 1). This aggregates together theprevalence of temporary tax codes, the number of relevantnewspaper citations and the divergence of forecasters forinflation and government spending. There is a clear spikein both uncertainty and the VIX index in 2008, and thenfollowing the start of the Eurozone crisis in 2010 theuncertainty started to rise (but the VIX moved faster). Moststriking has been the different reaction to the debt ceiling in2011 and to the fiscal cliff at the end of 2012. Uncertaintyshot up in 2011 and so did volatility. Despite the fiscal cliff in2012 being more risky than the debt ceiling in 2011, the VIXremained almost flat while policy uncertainty continued everhigher. This is risk habituation at work.To be fair, there have been policy efforts by central banksand governments to try to fix some of the problems, andthese may explain to some extent the more relaxed current
Joshua McCallum
Senior Fixed Income EconomistUBS Global Asset Management joshua.mccallum@ubs.com
Gianluca Moretti
Fixed Income EconomistUBS Global Asset Managementgianluca.moretti@ubs.com
Chart 1: Bored with that story
VIX index of volatility and the policy uncertainty index
Source: Bloomberg, policyuncertainty.com
Created by Scott Baker, Nick Bloom and Steven Davis
Policy uncertainty index (1m rolling avg, rhs)VIX Index (lhs)2013201220112010200920082007
The more that people are exposed to a risk, the less riskythat risk is perceived to be. This ‘risk habituation’ meansthat a number of headline risks that were significant acouple of years ago now cause markets less fear thanthey used to (even though some problems have arguablyworsened). There is a feedback mechanism at workbetween markets and politicians: the more optimisticmarkets are about the future, the less worried politiciansseem to be about finding long-term solutions. Theparadox is that if markets become optimistic about theprospects for policy, they make that very outcome lesslikely because they remove the pressure on politicians.

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