Fed Policy Consequences, Too Much Stock Market Volatility

Fed Policy Consequences, Too Much Stock Market Volatility

$VXX, $SPY, $DIA, $QQQ

The financial consequences of wider divergence among central bank policies are a stronger USD, great volatility in stocks and larger yield differentials among US and German bonds have been relevant over the last 10 days.

It is difficult to know how much the markets will move from here, the impact these moves will have on what central banks do next, and how the real economies will react in both the short- and longer-term. Understanding why is important for both investor positioning and policy formulation, says economist Mohamed A. El-Erian.

The 2  developments have refocused traders’ attention on monetary policy divergence are recent policy and economic signals including the US jobs report for October and comments from central bankers.

These may have increased the probability the US Fed will decide in December to hike interest rates for the 1st time in almost 10 years.

And there is the probably that the ECB (European Central Bank) may enhance its program of large-scale purchases of securities, known as QE, including by extending its duration beyond September 2016.

The behavior of the currency and bond markets has been consistent with finance textbook analyses.

This month, the USD has appreciated by more than 2% Vs EUR, and the yield differential between 10-year US and German bonds has widened by about 5 bpts in the context of higher interest rates. Both are likely to move further as greater policy clarity imposes itself on both sides of the Atlantic.

Textbooks are less useful in predicting the movement of stocks, particularly in light of the extraordinary support they have been receiving from central bank policies and from the deployment of unusually large corporate cash holdings.

Nonetheless, greater stock price volatility is to be expected in a market that has received big liquidity injections in recent years from global central banks committed to doing “whatever it takes + tax and license.”

So, it is not surprising then that the VIX already has increased by almost 17% in November.

The Big Q: What happens next, and how?

This matter for portfolio positioning, the financial system and economic well-being, particularly when it comes to the notion of volatile volatility.

The central banks actually want a greater level of market volatility overall.

But, they do not want to see too much turbulence, especially when it would be compounded by the more patchy liquidity that is now being provided by broker-dealers and other market intermediaries.

Excessive volatility threatens the central banks’ approach of generating growth through financial repression, and it would undermine the already tentative and struggling transition from liquidity- assisted economic gains to genuine growth.

If this were to materialize, too big a spike in volatility such as the one in August that drove the VIX above 40 would likely force the Fed to dampen expectations of a December hike. Such a delay would entice the Fed into continue relying on unconventional policies. That would amplify growing concerns about unintended consequences and collateral economic damage.

Trying to predict the extent of market volatility ahead is difficult because of the uncharted policy and market terrain created by the central banks’ unexpectedly long reliance on unconventional monetary policy.

It also is hard to be confident of the scale and scope of the effects on real economic activity and corporate earnings.

Should the Fed be forced to postpone its monetary policy normalization, the continued effectiveness of its unconventional approach will be subjected to increasing pressure, that will have an unwanted effect on the financial system.

Participants hope is that the Fed’s normalization process will bring about higher, but not excessive, stock market volatility.

We will wait to see.

Tuesday the US major markets finished at: DJIA +27.73 at 17758.21, NAS Comp -12.06 at 5083.24, S&P 500 +3.14 at 2081.72

Volume: Trade was below average with about 820-M/shares changed hands on the NYSE.

• NAS Comp +7.3% YTD
• S&P 500 +1.1% YTD
• DJIA -0.4% YTD
• Russell 2000 -1.2% YTD

Stay tuned…

HeffX-LTN

Paul Ebeling

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