Volatility is back! Depressed for years after the financial crisis of 2008 by zero-rate and quantitative easing (QE) policies of major central banks, markets are again responding to a variety of different and hard-to-forecast developments. In this report, we summarize six major debates feeding more volatile into markets. Volatility is back! Markets are again responding to a variety of different and hard-to-forecast developments.
There is solid growth in U.S. employment, despite a little less strength in March 2015, and a sense that deflationary pressures, driven in part by lower oil prices, are abating. These fundamental forces have placed the Federal Reserve’s debate on interest rates front and center. Will the Fed move to abandon the zero-rate policy and raise its target range for the federal funds rate in 2015 (Figure 1)? Our sense is that there seems to be a growing consensus among the hawks and doves within the Fed’s policy-making Federal Open Market Committee (FOMC) that eliminating negative real rates – that is, keeping the federal funds rate below the core rate of inflation -- is no longer appropriate after five years of solid, if not exciting, economic growth. The timing of any rate move remains in doubt. Q1/2015 real GDP may surprise on the weak side, and international factors including a strong dollar and a decelerating China, argue for a delay. The ebb and flow of the Fed’s rate debate is going to keep the short end of the U.S. maturity curve dancing, because the Fed has made it abundantly clear that its decisions are data dependent, and the data is simply getting noisier.
Within the debate about the timing of a possible rate-rise decision by the Fed, one scenario would have U.S. Treasury yields moving higher in anticipation – but this is not so clear. There are powerful global constraints on higher U.S. Treasury yields. The massive asset purchases by the Bank of Japan and more quantitative easing from the European Central Bank (ECB) and its Eurozone national central banks set for 2015 have driven 10-year Japanese and German bond yields below 0.40%. Even Spanish and Italian 10-year bonds now yield less than U.S. Treasuries (Figure 2). As conservative global investors search for yield, “high-yield” U.S. Treasuries will remain a favorite. The Fed debate may be driving the short end of the maturity curve, but BoJ and ECB QE are making it more likely that the yield curve flattens rather than experience a parallel upward shift. On the domestic front, the Fed ended its QE in October 2014, and growth in the supply of new Treasury securities is shrinking as the U.S. federal budget deficit fades away. Taken together, it is a prescription for substantial volatility within a wide range.
Growth in corporate-earnings is coming into the spotlight in the U.S. The lack of inflation in the U.S. has constrained top-line revenue growth, making earnings growth increasingly dependent on narrowing expense margins. Based on profits data contained in lagging real GDP reports, the earnings deceleration is well underway (Figure 3). While price earnings multiples remain in a comfort zone, and potential M&A activity can spur market rallies, the longer-term challenge to ever-rising stock prices is profit growth – or the lack thereof. This source of volatility is being magnified by the problems in the energy sector, where oil prices have tumbled under the weight of abundant supplies, as well as a possibly relatively weak Q1/2015 US real GDP, given: (a) savings on gasoline prices have not made their way into discretionary spending yet, and (b) the West Coast dock disruptions were more economically damaging than discerned by East Coast analysts. As earnings reporting season arrives, so may more equity volatility.
In the oil sector, markets appear to be settling into a very wide trading range, roughly $45-$60 per barrel in terms of WTI crude oil (Figure 4). While some rigs have been shut down, oil companies need to keep the oil flowing to keep the cash coming in so they can pay debts and bills. It is generally perceived by CEOs that taking some losses for a few years is much better than immediate bankruptcy, so cash flow trumps the economics of perceived break-even rates for production costs. For oil prices to break out to the upside, they would require: (a) severe disruption to the flow of oil from the Middle East, or (b) sustained and robust growth paths in emerging market economies, including China. The former is not likely, and the latter is not happening. China continues to see its growth rate decelerate, and indications are that it may be happening a little faster than the slow march downward as suggested by official government growth targets.
Gold is generally bought as a portfolio hedge when fears of financial instability rise or as a store of value in times of inflation. Neither of these factors is in play now (Figure 5). Indeed, if the Fed does move to push short term rates up toward the rate of core inflation in the U.S., then there may develop increased downside risk for the price of gold. On the global front, the two big bullion buyers, India and China, are headed in opposite directions. China is decelerating while India is experiencing robust growth under its new government. Volatility could emerge from an unusual source – the Chinese currency. The Chinese RMB has been managed in a tight range with the U.S. dollar, meaning that the RMB has been quite strong against most of the world’s currencies, along with the US dollar. The strength of the RMB has probably caused an even greater deceleration of Chinese exports; so if the RMB trading range were to be widened, weakness is possible. Any RMB weakness could spur Chinese demand for gold as a hedge.
The upcoming U.K. parliamentary elections in May 2015 may mean as much for the U.K. as they do for the European Union (EU). Interestingly, the outcome may hinge on Scotland. Scotland decided against independence in September 2014, yet the Scottish National Party (SNP) gained massive credibility. Now, with the elections for the Westminster Parliament coming up, the swing votes are in Scotland. If the SNP gains 20+ seats, it could mean a hung parliament with no one party gaining an outright majority. What is critical to note, though, is that if the SNP gains materialize, they will be at the expense of the Labour Party since the Conservative Party is defending only one seat in Scotland, while Labour is defending 40 seats. If Labour is denied a majority by the SNP, then a governing Conservative coalition becomes possible or a minority government rules by fragile compromises, from vote to vote. The underlying issue in Scotland, of course, is increased local governance. The big issue for Europe is that the UK Independence Party (UKIP) wants out of the EU, and they are pulling the Conservatives in that direction. If the Conservatives were in a position to hold a non-binding referendum on EU membership, as they have promised, it would probably add considerable volatility to the Euro, not just the Pound (Figure 6).
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
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