QE and Financial Market Volatility: Nothing Unusual

Antonio Fatas takes issue with Mohamed El-Erian's contention that QE is creating unusual levels of volatility in financial markets:

The New Normal is to forget economic history: Mohamed El-Erian in the Financial Times today puts forward again the argument that quantitative easing has generated little benefits and is now creating unnecessary volatility in financial markets. He presents the current monetary policy stance and the potential exit strategy as a unique experience that is generating distortions and volatility in financial markets that we have never seen before.

He uses two very simple examples of how bond returns are becoming volatile as interest rates start moving up. The logic is simple and well understood by anyone who understands bond markets: a fixed-rate bond that was issued yesterday will see its price change if interest rates move (in an unexpected manner) over the horizon over which the bond is outstanding. ...

Bonds that were issued in March under the assumption that interest rates will remain low over the next five years now look like a poor investment because the market today is looking at a scenario of higher interest rates. Without debating on whether the market is right or wrong, this is something that is standard in bond markets. News on future interest rates will cause volatility on bond prices. By reading the article one gets the impression that the current volatility is unusual and that it is the fault of the zero interest rate policy of central banks and quantitative easing. Quoting from the article:

"This dynamic was exaggerated when securities were artificially compressed by experimental central bank policy."

I can see the market is indeed getting worried about the exit strategy and that we are potentially heading for some volatile period in terms of interest rates. But what is not correct is to argue that what we are seeing is that unusual. Any time monetary policy gets tighter (regardless of the level of interest rate), we see volatility in interest rates. And in previous episodes we have seen volatility that is possibly as high or higher than what we have witnessed so far. ...

Putting the blame on this volatility on the central bank and the current monetary policy stance is not correct. Markets trade on differences of opinion about the future. Some will be right and some will be wrong and these will generate volatility in ex-post returns. While central banks can be proactive and provide forward guidance on their policies, they cannot control everyone's expectations about future interest rates. If we want to judge central bank policies and their communications we need to wait and see if the forward guidance they provided was a good indication of what they did later.