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Federal Reserve chairman Ben Bernanke (Carolyn Kaster/AP PHotos)
Federal Reserve chairman Ben Bernanke (Carolyn Kaster/AP PHotos)

If Fed tightens policy, VIX will shrug Add to ...

Many market watchers are flipping back to the year 1994, in the hope that the year’s surprise rate-hikes by the Federal Reserve will provide a decent template for the near future. The latest look-back tries to gauge what the volatility index is going to do.

The Fed will release its monetary policy statement on Wednesday, and some observers believe that it could signal an important policy shift, tapering its purchases of Treasury bonds and mortgage-backed securities. While easing back on bond purchases – known as quantitative easing – isn’t the same as interest rate increases, they are both considered forms of tighter monetary policy.

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In 1994, the Fed raised its key rate by a quarter percentage point in February, then continued to raise another five times until the key rate had climbed to 5.5 per cent by the end of the year, up from 3 per cent at the start. The Fed continued to raise rates in early 1995.

Bill Luby, who writes the VIX and More blog, looked at how the CBOE Volatility Index – or VIX, a closely watched measure of investor anxiety – behaved as the Fed’s key rate nearly doubled. Curiously, it responded with relative calm: The average closing value for the VIX in 1994 was just 13.93, closing above 20 on just two days in the year.

“The historical record from 1994 suggests that tapering fears may be exaggerating how the QE end game will ultimately play out,” Mr. Luby said on his blog.

We’ve pointed out before in this space that strategists are using 1994 as a potential template for how the S&P 500 will behave, too. Of course, it’s not necessarily a great comparison: The Fed has been providing extraordinary stimulus to the economy this time around, including dropping its key rate to zero per cent. The stock market has loved it, so no one is sure how the market will respond when the stimulus is withdrawn.

But as Mr. Luby points out, 1994 was in some ways more extreme than what investors will have to cope with soon: Back then, the Fed did not signal its intentions, and then-Fed chairman Alan Greenspan used cryptic phrases to describe policy.

“For this reason, it was difficult for the markets to anticipate the Fed’s next move and investors were not necessarily prepared for subsequent interest rate hikes,” Mr. Luby said.

Now, the Fed is communicating clearly and directly, and chairman Ben Bernanke adds to the policy statements by participating in quarterly press conferences – just to be ultra-clear on where the Fed stands. If the VIX was calm amid rate hikes in 1994, perhaps 2013 won’t be much different.

Follow on Twitter: @dberman_ROB

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