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reflections

Feb 7, 2018 | 00:47 GMT

5 mins read

After a Decade of Calm, Bigger Waves May Batter the Markets

A wild few days on the New York Stock Exchange may signal the return of market volatility.
(Spencer Platt/Getty Images)
It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.
Highlights
  • Market fluctuations in recent days show the connection between tightening monetary conditions and an increase in volatility.
  • This trend represents a return to the normal state of affairs that existed before quantitative easing.
  • Even if the latest episode proves fleeting, the increased volatility that it represents is expected to continue, especially as central banks continue to tighten monetary policy.

For Jerome Powell, Monday's first day on the job as the new Federal Reserve chairman was certainly memorable, but perhaps not in the way he might have wished. At one point during the trading day on Feb. 5, the Dow Jones industrial index took a historic intraday tumble, falling 1,500 points before rebounding to end the day with a 1,175-point loss. The record size of the drop may have grabbed headlines, but in terms of scope, the 4.6 percent contraction of the stock market index pales in comparison to previous bad market days — on "Black Monday" in 1987, for instance, the Dow plummeted by a whopping 22.6 percent. What is most notable about the latest episode is that the United States had enjoyed a period of relative financial tranquility, making the violence of these market moves particularly startling.

The consensus among financial commentators is that the market's steep downward movement (it had experienced a 666-point drop on Feb. 2) represented a much-overdue correction in asset prices, and was not the start of a longer fall or a crisis. That view was confirmed somewhat on Feb. 6 when the index rebounded to close the day 567 points higher. The next few weeks may well demonstrate that the two-day plunge was merely an anomaly and that stock markets will recommence the steady upward plod that has become so familiar in recent years. But even if that is the case, and this proved to be just a temporary market event, there are some indications that the market's roller-coaster ride might be an important harbinger of future behavior.

Forecast Update

In the 2017 Annual Forecast, Stratfor noted that a cycle of monetary tightening in the United States would bring more volatility to the markets: "Calm as markets have been recently, steadied as they were by ample liquidity and by muted responses to political upheaval, they will be much more volatile in 2017." That year ultimately proved as calm as the ones that preceded it, but rather than being wrong in our forecast, such deductions might simply have been made early.

The Chicago Board Options Exchange's Volatility Index, or VIX, offers a measure of the rate at which prices rise and fall and can be something of a bellwether of investors' confidence levels. When the VIX, colloquially known as the "fear index," is high, large price falls are more probable — it is sensitive to investor stampedes as they attempt to move their assets from risky products into safer ones. From the great depths that markets reached a decade ago during the global financial crisis, when the VIX hit 80 points, and then amid the eurozone crisis of 2011-12, when it reached 43, the index has gradually drifted downward to generally negligible levels. The VIX reached 28 during the Chinese devaluation of the yuan in 2015 and hit 26 in the wake of the Brexit vote, but the recent norm had been around 10. Until Friday that is, when the VIX suddenly shot up to 50 points. Given that no major geopolitical or financial event precipitated the spike, it was particularly striking.

Volatility is a normal part of market trading and in normal times stock prices are able to go down as well as up.

The proximate cause of the shock actually appears to have been positive economic news. The release on Friday of monthly U.S. jobs data showed early signs of wage growth. That was the trigger that markets have been waiting for, as it indicated that inflation may be set for a return, reversing a decade of deflation fears. The Federal Reserve, in turn, could respond to inflationary pressures by increasing the pace of interest rate rises, tightening market conditions and creating downward pressure on stocks. With stock prices still high after years of quantitative easing, the bubble received a small puncture and global prices rapidly deflated — though, thus far, only to a manageable degree.

In the decade since the 2008 crisis, central bank liquidity has tranquilized the global economy. Markets remained remarkably buoyant as money sloshed around, filling gaps and lifting all ships. Volatility has been so low that investors had begun betting against it, with one extremely popular instrument being exchange-traded notes that shorted the VIX. But the events over the past three trading days herald a shift. Since it began its latest monetary tightening push in December 2015, the Federal Reserve has now raised interest rates five times. Concurrently, the European Central Bank has begun to taper its quantitative easing program and pressure is building on the Bank of Japan to find a way to tighten its monetary policy. The market is beginning to lose its anesthetic as the cash dries up and, as a result, volatility is returning.

This is not necessarily a dramatically negative development. Volatility is a normal part of market trading and in normal times stock prices are able to go down as well as up. This is perhaps just the next step beyond quantitative easing, which in many respects will look a lot like the world did before central banks used the bond-buying technique to stimulate economic growth. Jerome Powell's first day of work at his new job may have been a rough one, but it was probably a good preparation for the world he will face at the helm of the Federal Reserve.

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