How Volatile Will Market Volatility Get?
The financial consequences of wider divergence among central bank policies -- a stronger dollar, great volatility in stocks and larger yield differentials among U.S. and German benchmark government bonds -- have been playing out over the last 10 days.
That was the easy part to predict. It is more difficult to determine how much these markets will move from here, the impact these moves will have on what central banks do next, and how the real economies will react in both the short- and longer-term. Understanding why is important for both investor positioning and policy formulation.
Two developments have refocused traders’ attention on monetary policy divergence. The first are recent policy and economic signals -- including the blockbuster U.S. jobs report for October and comments from central bankers -- that have materially increased the probability the Federal Reserve will decide in December to hike interest rates for the first time in almost 10 years. The second is the growing possibility that the European Central Bank may enhance its program of large-scale purchases of securities, known as quantitative easing, including by extending its duration beyond September 2016.
The behavior of the currency and bond markets has been consistent with finance textbook analyses. So far this month, the dollar has appreciated by more than 2 percent against the euro, and the yield differential between 10-year U.S. and German government has widened by about 5 basis points in the context of higher interest rates overall. Both are likely to move further as greater policy clarity imposes itself on both sides of the Atlantic.
Textbooks would be far less useful in predicting stocks, particularly in light of the extraordinary support equities receive from central bank policies and from the deployment of unusually large corporate cash holdings. Nonetheless, greater equity price volatility is to be expected in a market that had received such big liquidity injections in recent years, particularly from global central banks committed to doing “whatever it takes.” It is therefore not surprising then that the VIX already has increased by almost 17 percent in November.
What happens next, and how it happens, matter a great deal for portfolio positioning, the financial system and economic well-being, particularly when it comes to the notion of “volatile volatility.”
Although central banks expect -- and want -- a greater level of market volatility overall, they don’t want to see too much turbulence, especially when it would be compounded by the more patchy liquidity that is now being provided by broker-dealers and other market intermediaries. Excessive volatility threatens the central banks' approach of generating growth through “financial repression,” and it would undermine the already tentative and struggling transition from liquidity-assisted economic gains to genuine growth.
Indeed, were it to materialize, too big a spike in volatility -- such as the one in August that drove the VIX above 40 -- would likely force the Fed to dampen expectations of a December hike. But delay also would entice the Fed into relying on unconventional policies even longer, which would amplify growing concerns about unintended consequences and collateral damage.
In sum, predicting the extent of market volatility to come is inherently difficult because of the uncharted policy and market terrain created by the central banks' unexpectedly long reliance on unconventional monetary policy. It also is hard to be sufficiently confident of the scale and scope of the effects on real economic activity and corporate earnings. But should the Fed be forced into “extra innings” by postponing its monetary policy normalization, the continued effectiveness of its unconventional approach will be subjected to increasing pressure, which will have a ripple effect on the financial system.
The hope now is that the Fed’s normalization process, and what it entails for global central bank divergence, will bring about higher, but not excessive, equity market volatility. The best way to ensure this happens is for Congress to finally accept its economic-governance responsibilities and come up with a more comprehensive policy approach that includes pro-growth structural measures (including infrastructure investments), a more responsive fiscal policy (as opposed to the current extend-and-pretend approach), and more active management of existing and prospective pockets of crippling excessive indebtedness (including in the student loan market).
Unfortunately, the probability of this happening is quite low.
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