The Fed and the Roots of Market Volatility

Last week’s roller coaster ride in financial markets marks the worst bout of instability since the “taper tantrum” of Spring 2013. Stock market prices seesawed in the US, Europe and Asia, interest rates showed extreme volatility across the yield curve, oil prices plunged, and exchange rates lurched back and forth, depending on whether the day of the week was “risk on” or “risk off”. Local bubbles were popped, such as the large positions-of-record held by several hedge funds in the tax-inversion takeover candidate, pharmaceutical company Shire. The ordinary investor could be excused for wondering whether the markets had taken leave of their senses.

Actually, in my view, there was more reason, if not reasoning, to the market gyrations. The calendar conspired to bring together a number of economic, political and security concerns: ebola, Hong Kong, oil glut, soft economic data from Europe and China, and even a single month’s weak retail sales in the US. Investor confidence was undermined by bickering in the euro-zone over fiscal stimulus and, predictably, Greek, Italian and Spanish bonds sold off.

Underlying all of this was the simmering two-fold concern over central bank actions: How quick will the Fed be to tighten and how slow will the ECB be to ease? The divergent paths of monetary policy are well illustrated by the dollar/euro exchange rate, whose sharp movements in the last six months reflect the tectonic shifts (Chart).

US Dollar/Euro Exchange Rate: One-Year to Date

218Source: ECB

I believe that it is this concern over central bank actions that will continue to unsettle markets in the coming weeks and months, though hopefully not on the recent scale. I should like to focus on the Fed’s actions ahead of the upcoming October meeting since that meeting, along with the stream of earnings reports, will be the center of market attention in coming days.

The most important point to grasp is that the Fed’s actions to date have already had a marked tightening effect: the appreciation of the US dollar, in particular against the euro. By phasing out quantitative easing (QE) and through jawboning (“forward guidance”), the Fed has indeed tightened monetary conditions.

The implications do not, as yet, seem to be appreciated fully by the market.

One is that projected longer-run core inflation will be lower than it otherwise would have been. In plain English, that means the Fed has bought itself some breathing room-perhaps 2-3 months delay-before it starts to raise rates. That delay (e.g. from mid- to third quarter 2015) could well be signaled (in Fed-speak) in the October statement. There will not be a press conference this time around, but I expect the Fed’s FOMC members to talk about this effect in the weeks following the meeting. Such talk, together with the FOMC minutes, will tend to calm the markets. Acting in the same direction is the long-run (“pass-through”) impact of oil prices on core inflation. Nevertheless, I expect the Fed to end QE in October (despite James Bullard’s recent plea).

A second implication is that the Fed, in its pursuit of interest rate normalization, has a continuing communications challenge. My own view is that clear communication is no easy task and that the Fed has sometimes made matters unnecessarily complicated: think of the dots chart on the appropriate pace of policy firming. If QE is ended in October, as I expect, then sooner or later, the FOMC will have to change its language about maintaining the Fed Funds rate target “for a considerable time”. I expect the phrase to be dropped this time around and replaced by one indicating that timing is data dependent. That would provide the markets with some assurance of stability. In any event, the markets will likely come to focus more on the pace and extent of interest rate rises, rather than on when they start.

For the stock market investor, as opposed to the short-term trader, the conclusion is “Stay invested and stay the course!”