Citi on Central Banks and Volatility

Following up on Evans-Pritchard in yesterday's "Global watchdogs rattled by lack of fear in the markets".
From ZeroHedge:

Why Central Banks Need More Volatility (To Maintain Their Omnipotence)

Will volatility become a policy tool? The PBOC decided that enough was enough with the ever-strengthening Yuan and are trying to gently break the back of the world's largest carry trade by increasing uncertainty about the currency. As Citi's Stephen Englander notes, this somewhat odd dilemma (of increasing uncertainty to maintain stability) is exactly what the rest of the world's planners need to do - Central banks will need more FX and asset market volatility in order to provide low rates for an extended period... here's why.

Via Citi's Stephen Englander,
Will central banks need volatility to restrain asset prices?

• Cyclical and trend growth pessimism is leading central banks to guide expectations of rates downward
• The more credible the guidance, the more risk will be bought
• To prevent asset market overheating while keeping rates low, central bankers may have to introduce more volatility into asset markets...
• ...emphasizing risk and vigilance and central bank readiness to raise rates if needed

Central banks will need more FX and asset market volatility in order to provide low rates for an extended period. The argument goes like this:

1) Low realized and implied volatility have come as a surprise to investors

2) Investors are underinvested out of skepticism that the low rates, low volatility environment will persist

3) If the central bank mantra of “low rates, low vol forever” persists in asset markets, investors will buy high beta assets and add leverage

4) Asset prices will respond much more to rates incentives than (so-called) rates sensitive sectors of the economy

5) Central banks want to keep the low rates without creating an asset bubble and will purposely induce volatility to calm speculation

The big surprise this year is the reduction in FX and asset market volatility (Figures 1, 2) Realized USDBRL volatility over the last month is where EURUSD vol was in Q1 2013. Since it was unexpected, investors were underinvested and even wrongly positioned as volatility declined.

Investors were not convinced on low yields for well into the year. On April 28, US 5-year yields were 1.74%, much closer to the 1.80% year high than to today’s 1.52%. Two year yields were within 2bps of 2014 highs. Conversations with investors suggest that they are still underinvested in risk because they are afraid that a) the low rates, low vol environment will not persist and b) they are petrified that liquidity will disappear in EM and G10 carry trades if a negative shock hits. The image of picking up nickels in front of a steamroller is often invoked.

Fear is fading as carry trades have looked better and better. The correspondence between currency returns and higher yield has improved dramatically (Figure 3). Over the last month, the top five currencies appreciated 1.8% on average and had a carry return of 0.62%, the weakest currencies fell an average of 1.7% and had a carry return of zero. Put the other way, the highest yielders had a carry return of 0.8% and an FX return of 1.2%, the lowest yielders had a zero carry return and fell 0.7% on average....

...MUCH MORE