Global Macro: With Stimulus Cut, More Volatility

TheStreet.com

NEW YORK (TheStreet) -- iPath S&P 500 VIX ST Futures ETN rose sharply yesterday as the Federal Reserve reduced stimulus in a shaky economic environment.

The Fed is cutting its current monthly purchase of $75 billion in bonds to $65 billion, saying that the underlying trend in the economy is positive and that issues in global financial markets aren't severe enough to warrant keeping bond purchases at their previous levels.

The first round of stimulus cuts in December was welcomed, as market participants took it as a sign the economy was improving. Equity markets rallied more than 1% on the day of the Fed's announcement and continued to trend higher in the days following.

The idea of less central bank stimulus had been on investors' minds since May, and the equity rally after the announcement in December proved that the market was relieved the guessing game was finally over.

This time around, however, investors are unsettled that the Fed is no longer actively trying to keep financial markets afloat, and equities fell yesterday and the volatility index continued to rise. The volatility index had been increasing before the Fed meeting because of troubles in emerging markets and mixed U.S. labor data.

In recent weeks, speculators have shorted currencies in some emerging markets, overwhelming central banks' efforts to prop up their currencies. That happened in Argentina.

That caused a spike in volatility in global markets and led other emerging economies, such as Turkey and South Africa, to raise interest rates. That helped stabilize the Turkish lira and South African rand briefly, but the weak fundamental picture means central banks will be the sole defender against currency depreciation. That could mean more selling and volatility in upcoming weeks.

Meanwhile, jobs numbers in the U.S. have been weak. Only 74,000 jobs were added in December, versus a forecast of 195,000 jobs. At a time when the Fed is withdrawing stimulus, the shortfall was especially unsettling to investors. Payrolls data in coming months will be watched closely and will probably create huge swings in sentiment.

At the current pace of central bank stimulus cuts, complete removal of the program would occur by the end of the year. The Fed seems to want to end the program quickly, which shifts the pendulum back to fundamentals.

If the U.S. economy improves and the global economy shakes off issues in developing countries, the transition should be smooth and volatility should be low. If the global problems magnify, however, and the U.S. economy cannot keep pace with expectations, investor anxiety may reach levels not seen since the financial crisis.

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At the time of publication, the author didn't have a position in the fund mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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