Our sense at the end of 2018 was that the volatility being seen in markets at that time was episodic in nature. Yes, there were things to be worried about from a growth standpoint, but the rapidity and nature of price moves suggested that investors were perhaps more worried about short-term losses.
At the time, price action mirrored that of many ‘classic’ term-run episodes of the past: investors appeared to be seeking liquidity and stability by selling equity and buying government bonds and other safe havens.
Since then it has been quiet on the episodeblog front. While market volatility has a tendency to cluster, it is also the case that if we have been right in identifying an episode, volatility should decline as that episode corrects. This has indeed been the case, and there has been less to say as a result:
However, a notable observation for the year to date is that, while global equity markets have largely recovered from December’s drawdown, yields on government bonds have stayed at the lows and after the Fed decision yesterday, even drifted lower:
In Germany, not only have yields moved lower, but the moves in December hardly look episodic at all:
This is my truth, tell me yours
The stability in yields might suggest that yield declines in December weren’t about short-termism and panic at all. In fact, many would blanch at the interpretation of recent price action given above (behavioural assessments are often greeted with scepticism).
Instead, the consensus narrative for what happened is as follows: “the world was clearly slowing, but the Fed looked set on rising rates anyway which would threaten recession. Since then the Fed has realised this and changed course, rates will be lower for longer, and that puts a floor under equity markets.”
The two explanations are far from mutually exclusive. The more cynical might even say that it was the market panic itself that drove the Fed to change ( and Eric Lonergan would suggest that this isn’t necessarily a bad thing).
It is also likely that the prevailing motivations of investors have changed. Figure two shows yields initially falling with equity markets. This would be consistent with the behavioural explanation: if yield declines at that time had been about falling rate expectations, then why didn’t this support equities then in the way that they are apparently doing now? Most obviously, it is only in the last few months that the public language of the Federal Reserve has been more dovish.
Such backward-looking analysis can tie you in knots, cannot be proven either way, and is often more harmful than useful. However, understanding the motivations and behavioural predispositions of markets today is important.
If the consensus narrative is what people believe (or even what people believe that others believe), then markets could be vulnerable to surprise. The implication of the consensus narrative is that many equity investors are only prepared to hold stocks when US rates are at 2.5% , but not if they go much higher, or worse are simply playing a game of chicken with policy. Any sign of upward pressure on rates would therefore be a challenge.
This would be concerning because the markets’ degree of confidence that rates are anchored could well be worryingly high today. As well as the Federal Reserve itself suggesting that it doesn’t anticipate any rate increases in 2019, market implied rates are also suggesting a one way bet is being taken.
The chart below shows how this changed dramatically in November and December. By tracking implied policy rates at the Fed meeting in six months’ time, it suggests that there is no chance being given to rates after that meeting being higher than they are today.
And, just as volatility in equity markets has declined, so has volatility in Treasuries. The Merrill Lynch MOVE index, which measures implied volatility in US government bonds in the same way as the VIX measures it in equities, is at even lower levels than it was in 2017.
As investors we don’t want to be caught in a game of trying to know better than markets what will happen to fundamentals, especially on something so widely analysed as US interest rates. But if we acknowledge how frequently and dramatically surprised we are then we should be wary when market pricing suggests a high degree of confidence.
After all, for all the Fed’s more dovish talk, they are nevertheless data dependent, and data has a tendency to surprise. Last year illustrated how beliefs can go from ‘synchronised expansion’ to ‘global recession’ in a few months. If this was to reverse we could again see rate pressures prompting volatility in markets. Fortunately, if the reason for rate increases is strong global growth then this should ultimately be supportive for investors who favour equities from a longer-term perspective.