The unholy trinity of markets: uncertainty, opacity, volatility

Financial market volatility can have multiple causes but opacity and uncertainty play a key role, all the more so because they can be mutually reinforcing.

Watching the start of a formula 1 race on TV is fascinating. When the light switches from red to green, the 20 odd race cars, lined up in rows, start simultaneously. In day to day traffic, when the traffic light switches to green, cars tend to get going sequentially, which means that if you’re sixth or more in the line, lights may very well have turned red again by the time you arrive. Why is the reaction to the same signal (lights changing to green) so different? Visibility may be an issue in normal traffic: when a driver far down the line hardly sees the traffic light, there is opacity about the signal, which will instill greater caution. The incentive structures may also matter: participating in a race is different from driving to work or to the shopping mall. A key difference is uncertainty: even though the driver at the end of a queue may see the light switching to green, he will still hold off until he’s sure that the car in front has started to move: the driver behind is unsure about the action of the one in front: has he been paying attention to the signal? Wasn’t he checking his smartphone, etc.? This applies for every car in the queue and explains the slow, sequential starting.

The point is that uncertainty about the reaction of other drivers to a perfectly visible signal, forces a driver to react differently than if he or she would be alone in front of the traffic lights. This observation can be applied to financial markets as well. The way an investor reacts to a clear signal like the announcement of an interest rate hike by a central bank will depend on how they think others will react, simply because the reactions of all investors play a role in the pricing of assets in financial markets. This point was articulated many decades ago very clearly by the great economist John Maynard Keynes in the story about the beauty contest: members of the jury vote for those whom they think will get the votes from the other jury members.

In what I have discussed until now, volatility arises not because of opacity (the signal is very clear) but because of uncertainty about how others will react. It is important to keep this in mind as we get ready for the first rate hike since a very long time in the US. Though very much anticipated (the debate is essentially about ‘will it be September or December?’), it can still cause surprises because of the uncertainty about the reactions of others.

Opacity however also plays an important role: it is about information which exists but cannot be accessed, because nobody has bothered to collect and disseminate it or because there is a de facto reluctance to provide the information. An example of the latter is the question about the true objective of the Federal Reserve or about the indicators they are really looking at in deciding on the policy stance. Despite big efforts in terms of communication and an army of Fed watchers, there is still ambiguity about these points. Then there is opacity about investor positioning. Typically this only becomes clear once a shock has occurred. This has been illustrated recently in China. Once the stock market decline was gathering momentum, people came to realize there was significant ‘hidden’ leverage in the system, e.g. companies that had borrowed money using their own shares as collateral. Another element of opacity is market liquidity: will it be easy to trade big amounts in a stock or in a specific bond? If doubts arise about this, it will cause pre-emptive selling. Opacity about the true exposure of companies to certain economic factors (the dollar, the level of interest rates, the business done in emerging markets, etc) or about the intrinsic quality of an asset can also cause big price swings, thereby creating divergence from fair value.

Opacity increases the feeling of uncertainty and hence reinforces the nervous reaction to news that in itself doesn’t come as a surprise. It’s like being in your car in the middle of a queue in front of traffic lights in a poorly lit street at night…