The financial press is having a field day with the “Volfefe Index,” a measure discussed in a September 6 research note from JPMorgan. The index measures the likelihood that President Trump’s tweets have moved the bond markets. In building the index, the bank found Trump’s tweets have become increasingly likely to move the market in recent months, and they have especially tended to do so when they have been about China, trade, monetary policy, or the Mueller investigation.
An obvious question about a research note like this is: Why was it published? Investment-bank research desks are not in the “fun facts” business, much as those of us who sort of are in the fun-facts business might like them to be. They also don’t tend to want to put out documents that might look like political commentary. How is a JPMorgan client supposed to take this information about the Volfefe Index and use it to make money?
The answer has to do with swaptions, or options to enter into interest-rate swaps. Swaps are financial products in which the buyer agrees to pay a fixed interest rate and receive a floating one, or vice versa, over a given time period. A swaption gives you the option to enter into a swap on specific terms at a time in the future or not: You get to decide, based on how interest rates have moved since you bought the swaption.
Swaps and swaptions allow market participants to manage interest-rate risks. For example, if you’re a bank that has made a lot of fixed-rate loans but pays interest to depositors at a floating rate, you might use swaps to convert some of your fixed-rate loan exposure to a floating rate. And the way swaptions are priced depends in part on market expectations about how much interest rates might move around between the time you buy the swaption and the time when you can exercise it.
The JPMorgan analysts looked at a measure called “implied volatility,” which is derived from swaption prices and reflects how much market participants expect interest rates to move around. This measure has gone up a lot lately, especially for soon-to-expire swaptions tied to short-duration swaps. Essentially, swaptions are becoming more expensive because market participants think interest rates, especially short-term interest rates, are more likely to move around enough, such that people who buy swaptions will want to exercise them.
A question one might ask is whether this increase in implied volatility — which, to be clear, is a measure of market expectations of volatility, not a measure of actual volatility — is warranted, given current market conditions. JPMorgan has a model it uses to estimate what implied volatility associated with a given swaption ought to be, given certain observable facts about the markets and other conditions. The trouble is this model has not historically included a parameter about the president’s tweeting, which may now be a relevant input.
So this is why JPMorgan analyzed that database of Trump’s tweets, looking to see how often they were immediately followed by material interest-rate movements and what characteristics those apparently market-moving tweets tended to share.
It’s important to note that this model is not extremely precise: JPMorgan categorized 146 Trump tweets since the start of 2018 as market moving but said 30 or more of those are likely false positives, tweets that just randomly happened to occur ahead of a change in interest rates. On a prospective basis, the model is able to pick out a market-moving tweet only on the basis of its content one time out of three. That’s all okay, because the important thing is not what the model says about any given tweet but what it says about them in the aggregate. By looking at all the tweets together, JPMorgan can say with specificity that the president’s tweets have been getting more and more likely to move the market, even if it can’t identify which ones are the specific culprits.
The index that results from this measure, the Volfefe Index, can be plugged into JPMorgan’s valuation model for swaptions. What it finds is that the increase in implied volatility reflected in swaption prices does appear to be justified by actual increases in market volatility being caused by the president’s Twitter behavior, at least as regards swaptions tied to near-term moves in short-term interest rates — that is, these financial products are becoming more expensive because the president’s tweets are causing a real increase in interest-rate volatility.
Around a decade ago, you heard a lot about the problem of “policy uncertainty.” The claim was that financial markets and the economy were being dragged down by an uncertain policy environment. Investors didn’t know how much they would be taxed or what sort of regulations the government would impose, so they were reluctant to make risky investments.
Typically, this is just a talking point people use when they dislike a policy proposal that is under consideration. But uncertainty can impose real costs. And the Volfefe Index is clever and useful because it has isolated a real effect of policy uncertainty: We can see, in real time, the president making a financial product more expensive through his public commentary that makes interest rates less predictable.
If these effects were limited to the swaption prices JPMorgan can measure, they wouldn’t be so important. But obviously, swaptions aren’t the only product whose cost is affected by increased interest-rate volatility. People whose businesses depend on the cost of borrowing or lending in the future — bankers and real-estate developers, to take two examples — face more risk when the interest-rate environment is more volatile and will find it more difficult to make investments. The JPMorgan note shows how the president is making their businesses more difficult in a quantifiable way.