The European Central Bank and market sensitivity

We have noted before that there has been a rise in the incidence of high volatility days since the introduction of negative deposit rates in continental Europe in June 2014. This, in turn, raised an interesting question:
If the introduction of a negative deposit rates by the European Central Bank [ECB] in 2014 fed through into a measurable rise in the number of high volatility events (and more generally in volatility), then what would happen as policy was eased even further?

With four rate cuts – including the original move in summer of 2014 – and three rounds of quantitative easing (QE), we now have some tentative evidence to consider.

While the 11.78% reading in overnight volatility (measured on an open/high/low/close basis) for the euro/US dollar (EUR/USD) seen in the aftermath of the June 2014 rate announcement by the ECB might have seemed dramatic in the context of the ultra-low volatility seen over the previous six months, this was hardly exciting stuff. Indeed, this barely made it above the average reading for overnight volatility for EUR/USD of 10.98% for the entire history of the EUR.

Given that central banks are not – normally – in the business of creating untoward volatility in markets, the governing council of the ECB must have been comforted by this outcome. Although the reading in the aftermath of the September 2014 rate cut (to -20 basis points) was higher (12.39%), this must have encouraged the board to believe that there were few signs that their increasingly unconventional approach to monetary policy was feeding through into market unrest.

It seems reasonable to suppose that this view was challenged by the volatility seen in January 2015 following the announcement by the board that it was introducing a €60bn per month quantitative easing (QE) programme that would run until at least September 2016. The reading of 28.03% in EUR/USD overnight volatility seen in the aftermath of the decision made this the 28th most volatile day seen in the currency pair’s history – putting it in the top 1% of days. However, it is entirely possible that this was seen at the time as something of a one-off, given that the policy move clearly presaged the next chapter of the Greek crisis.

No such excuse can be found for what happened last December, in the aftermath of another 10bp cut in the deposit facility rate and an extension by six months in the minimum length of time the QE programme would run for. This time around overnight volatility hit 31.5%, making it the 17th highest reading in the currency’s history. While it might be argued that this was down to market disappointment at seeing only a 10bp move, the fact is that this move still took ECB policy into territory that only a handful of other – and far smaller – central banks had ever explored.

Geopolitical insensitivity

There was a further curious feature to the volatility seen in the aftermath of last December’s policy meeting: it stood in sharp contrast to the remarkable lack of volatility seen in the face of genuinely significant geopolitical events around that time. These included the downing of two jets by Turkish forces and the terrible events in Paris occurring on November 13.

Examples of this geopolitical insensitivity had been evident even before the introduction of negative interest rates – most obviously in the indifference to Russia’s takeover in the Crimea – and had continued to be evident as the situation in the Levant and North Africa continued to deteriorate. For those who recalled the market’s sensitivity to geopolitical events through the 1980s and 1990s, this was particularly noteworthy – indicating a financial world in which monetary policy issues drowned out absolutely everything else.

The events of late last week provided yet more evidence of this trend. This time the reading in overnight volatility – following yet another 10bp cut and a €20bn increase in the QE programme – came in at 32.74%, making this the 13th most volatile day in the currency’s history. To put this into context, EUR/USD has only seen greater overnight volatility in September 2000 – following multilateral central bank intervention to support the single currency; during the fourth quarter of 2008 at the height of the financial crisis; and – tellingly – in March 2015, when Janet Yellen tweaked investors’ expectations about the pace of the Federal Reserve’s policy tightening.

Again, it is possible to argue that there were extenuating circumstances for last week’s wild swings – general comments about it being unlikely that the ECB would cut further – but this was still an astonishing reading. It also stood in very sharp contrast to the utter lack of market reaction to the test firing of two missiles by Iran with “Israel must be wiped out” written on the side in Hebrew, or the heightening of tensions on the Korean peninsula.

So where does this leave us? While some might argue that specific reasons can be found for each of these days of high volatility, the simple fact is that each policy move by the ECB since the summer of 2014 has been accompanied by a reading in overnight volatility that was higher than that seen the previous time around. Moreover, the volatility seen on the past three occasions is demonstrably extraordinary. This also stands in sharp contrast to the lack of volatility seen in the aftermath of geopolitical events that, in more normal times, would have created a significant amount of market turmoil.

We have spoken before about the “gravitational” effect that negative deposit rates appear to be having. Perhaps these observations about the shifts seen in overnight volatility readings provide some tentative evidence of this effect increasing, the further the deposit rate is taken into negative territory. If central bankers, typically, wish to avoid creating untoward disturbances in financial markets then this is bad news.

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