Some big moves in the Dow Jones, the S&P500 and, to a lesser extent, the ASX200 have caused discussion amongst investors and prompted suggestions that we are in a high volatility environment.
There is no doubt that the recent pick-up in volatility seems high compared to the significantly low levels we’ve seen throughout most of 2014. But the volatility is not as alarming as many commentators would lead us to believe; and certainly nowhere near as turbulent as the levels we saw during the global financial crisis.
Which leads me to my next point – if you watch the equity markets only then you are missing the story. The main market action is currently occurring in US T-Bonds, FX and Oil.  This is where volatility has certainly increased.  The equity markets are simply along for the ride.
Essentially, there was a flash crash in US T-Bonds in October. However rather than losing value, T-Bonds rallied as if the equity market was falling. The size and volatility of the move in T-Bonds is what you would expect to see if the US equity market is selling off 10% or 15% in a day. The difference was that this time the T-Bonds were leading equities – not the other way around.
Things are changing in the T-Bond market. Yields are very low so the risk is becoming very skewed. US short-term rates are expected to rise putting a floor under how far T-Bond yields can fall.
Also changes to banking and derivatives regulation mean financial institutions need to hold more collateral to offset financial risks. This collateral may be held as cash and quality assets like T-Bonds. These small percentage changes in collateral requirements add up to very large dollar amounts of T-Bonds.
So the recent moves in T-Bonds could be caused by a hunt for collateral and liquidity issues instead of a change in expectations on Fed policy and inflation.
The lower oil price is also playing a role as it feeds global deflationary fears. But energy prices have a similar impact to a tax – if oil prices remain low, the benefit for global economic growth will offset deflationary pressures. Just like in the opposite scenario, when higher oil prices have a slowing effect on the global economy.
We believe it is unlikely that any of the recent market events will cause the Fed to change its course, especially as global flash PMI numbers have also come in stronger than expected – including China, Europe and Japan.
In Europe, monetary easing has been increased and Japan is likely to follow suit next year. Whilst in China, growth has come in above expectations despite the property market continuing to weigh on the economy. The strength of China’s employment market is one of the key takeaways from the recent flash PMI.