4 minute read
After a turbulent spring, many corporates and investors welcomed the calmer market conditions of recent months. Volatility is far from over though. Read on to find out why.
Massive monetary and fiscal policy responses helped to restore some level of equilibrium in turbulent markets during the coronavirus crisis, creating calmer markets despite unprecedentedly weak economic growth. Risk asset prices have risen sharply since their mid-March bottom. Indeed, for brief periods last week the Standard & Poor’s (S&P) 500 and German Deutscher Aktien Index (DAX) were positive on the year. At the same time, core bond yields have been anchored at record low levels. To add icing to the cake, central banks have managed to boost inflation expectations. With that yield levels have plunged to record low levels.
While policy-makers can plug holes with stimulus to help markets function as normally as possible, in the unstable world the coronavirus crisis has created the leaks in the plumbing will eventually show. There are plenty of reasons to think this is already starting to happen and volatility will head higher again. Here are five potential catalysts for the next volatility spike.
1. Market volatility catalyst:
The weaker US dollar trend looks set to continue
Broad dollar (USD) weakness has been one of the biggest trends in macro markets in recent months and there is reason to think it will continue. The decline has initially been driven by strength in European currencies as adoption of the Euro Recovery Fund significantly diminished the risks of a euro area break-up. The next stage of dollar weakness is likely to be more home grown. A badly managed coronavirus crisis is feeding into weaker growth, just as the US election season kicks off. Weak growth and concerns around a Democratic sweep in the November Election will put downside pressure on US assets and the dollar.
2. Market volatility catalyst:
The surge in precious metals signals diversifying investor interests
The nature of the recent dollar decline and its link to the surge in precious metals prices is important. In July alone, silver rallied 25%. Gold is up 8% and is now safely through the 2011 peak. The combination of a plunging US dollar and surging precious metals suggests the initial consequence of the massive coronavirus policy response is that investors increasingly see little value in cash. With the record low level of real yields, this is to be expected. But a plunging dollar and investor aversion around the value of cash highlights how unprecedented monetary and fiscal policies are coming at a cost. The combination also raises questions about the uncanny calm in core bond markets today.
3. Market volatility catalyst:
Credit markets face a more difficult period ahead
While high levels of monetary and fiscal policy support have helped boost credit market performance, the outlook from here is far more uncertain. There two big risks posed by the unprecedented support from fiscal policy.
The first risk is government bond markets, from which credit markets derive a large portion of their total returns. So far, government bond markets have taken the surge in issuance in stride. But the US dollar movements and surge in gold prices suggests investors are questioning the value of cash as an asset. The other potential investor concern is inflation. Many question if inflation is really coming back but despite record low nominal yields, break-even inflation levels keep rising. Its possible inflation markets are trying to tell bond markets something.
The second risk for credit markets is fiscal policy fatigue. If wage, tax and interest payment supports have kept companies solvent, what happens if they are taken away? I’m inclined to think fiscal policy will remain a support for a long time to come but current dynamics in Washington show this should not be taken for granted either. After passing two unprecedentedly large fiscal packages with relative ease earlier this year, the third package is proving much harder.
4. Market volatility catalyst:
Second virus waves add to the uncertainty
While lockdown measures are easing globally, some of the countries that were early success stories are now seeing significant second waves. Steep case rises in Israel, Japan, Australia and parts of Central Europe show the risk of second waves are real and cannot be ruled out until a vaccine is a widespread reality.
With governments reluctant to shut their economies again, the focus will be how well case spikes are managed. It is notable that consumer confidence has lagged the general improvement in global sentiment. Consumers need to be a big part of the global recovery and they are currently suffering from a double whammy of continued coronavirus fears and historically weak labour markets.
5. Market volatility catalyst:
Summer is the season
Finally, August is the most seasonally bullish month for implied volatility, rates markets especially. Rates and foreign exchange (FX) volatility have risen in August in nine out of the last ten years, including the last seven years in a row.
As you can see in the below chart, the pick-up in implied volatility has thus far been negligible but if you look hard, you can see an increase in FX volatility.