Volatility,stressandtheconceptofantifragility

The US 10-year yield is trading at 1.54 currently down from 1.59 levels seen on Monday. The easing in yields was on the back of fulsome demand in the auction of 3-year treasury notes which took place yesterday. Readers would remember that the recent rout in the bond markets started when a 7-year bond auction failed to garner enough buyers prompting investors to start paring their bond position across the curve in the secondary markets. Reasons like inflation expectations, overheating of the economy and permanent stimulus were touted to explain the panic. The equity markets have taken the cue from bonds and are trading in green. The emerging market currencies have also shown a pull back with currencies like INR and ZAR trading better from recent lows. As none of the underlying reasons have either improved or deteriorated, one can only surmise that markets have certainly become more volatile.

Coming to talk about the volatility, one needs to answer a philosophical question whether volatility is good or bad for the markets? The answer to the same can be found in a concept called antifragility which is championed by Nassem Taleb in his books. The point which he makes is that antifragile are the things, systems, dogmas which gain strength during the times of stress. In a sense, Volatility in markets actually make them more antifragile as the participants become more aware and alert of the uncertainty surrounding their actions. They start to look out to hedging their exposures, making themselves more robust. New markets and products get developed in response to the new demands, for example as the yields become more volatile the demand for finely priced OIS products would rise, making them more efficient. Slowly the bespoke OTC products offering the basis cover on OIS and Gsec would emerge and the overall market will become more efficient. Nothing is more detrimental than a make-believe world of apparent tranquillity hiding stress beneath the carpet.

Let’s give one example from the mid 90’s. The East Asian countries like Thailand, South Korea, Philippines and Indonesia had kept their currencies pegged against the US Dollar. The companies in these countries borrowed heavily in Dollars and the investors across the world were happy to humour them. The stock markets in the East Asian countries delivered amazing returns for few years. The tide turned in year 1995 when the dot com boom in the US started and the hot money started returning to the US to be part of the boom. As the outflow deepened, the central banks in the East Asian countries found it difficult to maintain the peg and tried using all the reserves to defend it. The general public though still had a belief in the peg and was unaware of a looming tsunami. Finally, in 1996 the Thai government decided to abandon the peg of 25 Thai Baht to the Dollar and all hell broke loose. The investors pulled out Dollars from all the East Asian countries making it a region of wide phenomenon later dubbed as the East Asian currency crisis. The peg was not volatile but was fragile. Currencies now are more volatile but at the same time more antifragile also with no covert promise of stability. Market participants must fend for themselves to protect their skins.