Are you surprised by choppy stock trading, attention-grabbing swings in the Dow (^DJI), and heightened volatility in other segments of the financial markets, including US Treasuries?
You shouldn't be.
A simple framework helps to explain these bouts of volatility, as well as shed light on what’s ahead.
With overall valuations historically “rich,” small changes in two “conventional wisdoms” can have outsized influences on daily market action: that governing global growth and, therefore, the prospects for corporate earnings; and the characterization of central banks, particularly their willingness and ability to repress financial volatility.
While global growth has consistently fallen short of potential in recent years, markets have been generally conditioned to view it as relatively stable. Even the characterization of its composition has been quite stable when it comes to the most systemically-important economies.
Specifically, the United States out-performs other advanced economies, with a growth rate in the 2%– 2.5% range. Europe and Japan plod ahead at around 1% -1.5%. China and India lead the emerging world, with the soft-landing in the former compensated by a growth acceleration in the latter.
Concurrently, conventional wisdom characterizes central banks as both willing and able to step in periodically and repress financial volatility — this as part of the advanced world’s overall reliance on unconventional monetary policies to promote economic growth. In the process, persistently low interest rates and large-scale asset purchases have given way to the emergence of negative yields in both Europe and Japan.
Every once in a while, one of these two characterizations is questioned. And when both are queried simultaneously, as was the case last January-February, the spike in market volatility can be quite pronounced and unsettling.
Starting late last week, many traders’ comfort with the central bank backstop — which has been conditioned by several years of actual experience — was shaken by remarks by Fed officials suggesting that markets were under-estimating the possibility of early interest rate hikes by the Federal Reserve. This was amplified by Wednesday’s release of the minutes of the April FOMC meeting.
With that, fixed income markets have moved quite a bit in the last few days to (correctly) reprice the likelihood of a less dovish Federal Reserve. Significantly higher 2-year yields have led a noticeable flattening of the US Treasury curve to a level not seen since late 2007. In the process, stronger volatility impulses are being transmitted to other financial market segments in the US and around the world, be it stocks or currencies. The outcomes have included triple-digit intra-day moves in the Dow, a spike in the VIX, and some equity markets more than rapidly erasing their gains for 2016 as a whole.
When placed in a historical context, however, the recent moves in markets are not that remarkable.
For the last two years now, US stocks have been largely range-bound, with occasional sharp moves both up and down. Most of these moves were triggered by changes in the two characterizations cited earlier. And once these catalysts were triggered, stocks tended to overshoot, again both higher and lower, due to patchy market liquidity – a phenomenon that is particularly impactful for the most widely-held stocks and for other securities that have a limited base of dedicated investors (such as emerging markets).
Absent a policy mistake or a market accident, this overall behavior is likely to continue for now. But when placed into a broader context, it is far from certain that the anchors (of low but stable growth and central bank effectiveness) will hold in the context of a consistent increase in a set of underlying tensions and contradictions – economic, financial and political.
The most likely outcome is for more frequent and sharper fluctuations within a range that gets wider over time. Thereafter, and within the next three years, a more definitive breakout is likely. Whether this proves beneficial for markets is a function of politics — namely, whether politicians on both side of the Atlantic finally step up to their economic governance responsibilities and enable the much-delayed handoff from excessive prolonged reliance on central banks to a broader policy response.
Mohamed A. El-Erian is the chief economic advisor to Allianz, the corporate parent of PIMCO where he served as CEO and co-CIO (2007-2014). He is Chair of President Obama’s Global Development Council and the author of two New York Times Best Sellers: the 2008 “When Markets Collide” and this year’s “The Only Game in Town.”