Transcript of Question & Answer Session Volatility and Market Pricing

Thanks for your talk, Guy. I had a question. You mentioned earlier that the period of low volatility seemed to, sort of, go hand in hand with moderate growth or average growth in the global economy, I’m just, sort of, wondering if, as we move into this, sort of, higher volatility world whenever that might be, whether that, sort of, says anything about the implications for global growth, particularly as you say it’s quite likely that that transition in volatility could be quite violent and messy.

So not necessarily. So there, so if take … I mean ‘94 is actually a decent example, right. So there was a spike in volatility in’94. There maybe was a bit of a mid-cyced at best, a mid-cycle pause in global growth, but the global economy … the second half of the nineties was a good period for the global economy, so obviously 2008 was volatile, that wasn’t a good period for the global economy and there was a bit of two-way feedback between markets and the real economy going on then. So not necessarily. I mean, so if the trigger for a rise in volatility is the market perceiving that the front end of the curve in the US is actually going to lift off zero, and the reason why that is the case is because the US economy is strong, that’s probably … That’s the case where you might well have decent global outcomes in the face of rising volatility, so the two … I don’t think there’s necessarily any relationship, it really depends what the trigger is. If it’s a, sort of, ‘07/’08 trigger for volatility, probably not good for the global economy. If it’s a fact that the US economy is surprisingly strong, which is not far away from what we were looking at in’94, then that isn’t necessarily going to derail the global economy.

Roy Robertson, Westpac Group Treasury, Guy. Thanks for your talk. You seem to suggest that your former advisor, Stan Fisher, joining the Fed has the Fed thinking, sort of, more broadly about global stuff or maybe he just thinks more about global stuff and other people have caught on. The world seems to be struggling to create inflation. The Feds had this, sort of, dream run for five years with jobs growth and unemployment has come down from 10 per cent to under six percent, but wages growth is still two and inflation the last few months has annualised at about one, so the US is struggling to create the inflation it wants, the Fed wants before it hikes rates. Europe’s struggling against deflation, Japan is still struggling against deflation, China’s slowing. The worry is, and all these interest rates seem to be particularly low because the world’s struggling to break out of this deflationary rut. Is that fair or what’s your sense of all that?

I mean, that’s a possible explanation. I mean, inflation in the US has been, it’s been not … It hasn’t been quite two, but it’s been one point something, or one and a half for a while, so its not so low. I mean, clearly that’s a concern. It’s very much a live concern in Europe and is very much why the ECBs is doing what they’re doing. It’s hard, I mean, one thing I’d be say, is careful what you wish for, particularly if you’re a fixed income investor. I don’t think you’d necessarily wish for a particularly marked rise in inflation, a bit more is probably okay. But again, if I look at … And if you take treasuries at 228, there’s not a lot of risk price in there of a rise in inflation anytime soon, that said, at the moment we’ve got declining commodity prices, particularly declining oil price which, at least in the short term, is downward pressure on inflation although it’s probably not all that bad for growth, at least, in the US. So, I mean, you’re right, there’s not a lot of inflation out there at the moment. I would guess that if labour markets, particularly and most obviously in the US continue to tighten at the pace they’ve done so over the past 12 months, you get that over the next 12 months, I’m suspecting in that environment you’re probably not going to continue to get the benign wage outcomes that we’ve seen to date. So, it may well end sooner than you think, it may well last a bit longer as I said, particularly given you’ve got the disinflationary pressure coming from commodity prices. By the way, the stands of arrival of the Fed didn’t, they did realise I was being facetious. They did realise there was some part of the rest of the world out there before his arrival.

Quick question on your point that markets should not listen to Central Bank, and in particular, is that specific to the current environment or is that a broader comment about the benefits and costs of forward guidance in general?

I mean, markets need to listen to what Central Bank says, they just don’t have to take it at … My point, don’t take them at their word, so think for yourself and think whether what they’re saying actually makes sense and as I said, again, go back to’94, to some extent … I mean, the markets did actually at least, for a short period, think for themselves during that period. I mean, the forward … Well, I mean, so Central Banks, I mean, you’re getting more … I mean, if the Central Bank’s reaction function is reasonably clear, then the market should be able to work out what the future path of interest rates is without the Central Bank necessarily, explicitly laying it out in terms of forward guidance. When you’re in extreme situations like the US is in and now the European’s are in and Japanese have been in for a very, very long time and you’re doing stuff with your balance sheet rather than with interest rates, its much harder to work out what the reaction function is, so I think that’s why it’s become much more prevalent in the last few years, is because Central Banks have been in extremes, at least in terms of interest rate settings and its not clear what the reaction function is and most obviously in the US, they want to make it clear … Make sure that the market doesn’t misinterpret what their reaction function is going to be. Once we move back into a world, hopefully some day soon, where we’ve got more normal settings and changes in monetary policy in terms of short-term interest rates moving up and down, then again, as long as your reaction function’s clear, forward guidance is basically moot and the market should pay as much attention to it as anything else and as I said, it should be able to feed in its own expectations into that reaction function and work out what that implies for the path of rate which may or may not be the same as the one the Central Bank’s laying out. Down the back. Sorry, right down the back.

Hi there, Aleysha Barry from the ABC. Just a very consumer question. Given the fall in the Australian dollar over the last month or so, down six per cent, does the RBA see this as fair value or would it like to fall further?

I just said that. That I don’t think … I still that’s higher than where fundamentals would have it, so.

Okay. Thank you.

Thank you for the presentation. You mentioned that there are non-traditional sellers of volatility in the market right now. What do you think should be the right policy or regulations to pursue, to actually limit that type of activity in the market?

I’m not sure that there’s necessarily any, people are allowed to take the investments that they want to take, I’m not sure there necessarily need to be restricting that, all I’m saying is those non-traditional sellers of volatility may well disappear faster than traditional sellers of volatility projection, so that may well make the market dynamic somewhat different from what it’s been in the past in that, once … But to the extent that they’re actually incurring losses and this is true also when I was talking about the assets which are out there which are predicated on zero funding costs, if they’re sitting on the balance sheets of real money investors, then from a financial system point of view, that’s necessarily not so bad. Not so good for the real money investor themselves or for their … Or the people who have got money with them, but to the extent that they’re incurring loss, it doesn’t necessarily imply dysfunction in other market segments, whereas if its city who’s the one who sold the volatility for protection and starts incurring large losses that potentially has affects on other lines of business and so, as I said, not being on the balance sheet of the core banking system, at least directly, probably a good thing, but if its real money investors out there are not sure that we necessarily need to be regulating as to what is or is not an appropriate investment for them, all I’m saying is that that may change the market dynamics when … Once things actually finally turn.

Guy, I think, terrific presentation. I think, central to what a lot of investors are thinking to speak of Stan Fisher. In his comments over the weekend at the IMF, he openly admitted that part of the goal of QE is to influence asset prices and to create a wealth effect and after everyone of these spikes in volatility, certainly since 2007, you’ve seen a major response from, at least, the big two or three central banks to do additional stimulus and additional QE to, again, support asset prices higher. Is it the reaction function of the big central banks that are, in fact, causing this and do you believe that, we’re in a different dynamic now that, perhaps, any further bouts of volatility won’t be resisted by central banks.

Sorry. Another way of framing your question … So I don’t think there’s a central bank put under assets prices, which is another way of framing your question. So why did central banks respond, there was … I don’t think it was necessarily a response to the volatility, per se, it was a response to the events which caused that volatility back in’08, or in, the developments in Europe at the moment are a response, as Rory was talking about, to the evolving inflation environment there, rather than any particular market development. So I’m sure markets have, as you said, I mean, and as you mentioned, one of the main transmission channels of QE is underwriting. It is trying to boost asset prices and trying to generate more risk-taking behaviour ultimately to generate a pick up in the real economy, its not underwriting the asset prices themselves, that’s just part of the transmission mechanism. Any time central banks make policy changes, that changes some asset price or another and this is just a somewhat different form from what’s been done in the past. So I’m not sure that … So I wouldn’t say the reaction function is necessarily changed, if there’s a real economy development which is going to warrant a policy response that will happen, and to some extent in relation to Paul’s question, you can have volatility which doesn’t have real economy consequences. If that’s the case, I don’t see the central banks, necessarily, rushing back into to underwrite those asset prices. I mean, I think, one thing thinking about these different markets and thinking about the effect of QE on asset prices, so if you think the ultimate goal of QE was to, sort of, refloat the nominal economy, right. So if you’re successful in doing so, then basically, that’s going to underwrite, that’s going to justify equity prices, so equity prices may move ahead of that, but if the policy is ultimately successful and you get those nominal growth outcomes, then basically, that’s going to underwrite the equity prices. I’m not saying equity prices may have overshot in the meantime, but broadly speaking, that underpins it. If you think about fixed income though, that’s not the case. So if you are successful and you do reflate the nominal economy that doesn’t justify bond yields where they are at the moment, so to some extent, there’s a big of … a bit of substitution between investors in assets classes there, if the policy is ultimately successful, which, I think, is, sort of, interesting to think about again in terms of what the nature of any sell-off might be if and when it finally comes.