By now, we have all seen and lived through some of the most volatile markets since 2011. While 2011’s volatility was due to the first Euro sovereign debt crisis, this year’s variety comes on the heels of China’s currency devaluation and the global slow down implied by these actions. The implications from these concerns are wide ranging and has potentially impacted all asset classes. Equities have so far borne the brunt of these are concerns, with the VIX topping 40 a week ago, over 3 times higher than where it stood at the start of August.
Some of the headlines generated by the equity markets included an opening plunge of over 1,000 points on August 24th, which has been followed by 200+ point daily moves in 6 of the past 8 trading days. Oil has been a litmus test for global growth all year, and we have seen both Brent and WTI retest their YTD lows only to be followed by the largest rally in 25 years at the start of the week. This has been subsequently followed by an almost complete reversal the following day (we are currently at last Friday’s levels as we write this). Whether this level of acute volatility is the new normal during strong risk-off periods has been a growing concern for investors all year. For our part, we are in the camp that this is the new normal as the currents created by central bank policy, evolving liquidity dynamics and changing global reserve management makes their way through the investment process. Our observations are that while we have been aware and discussing each of these issues in isolation over the past year, China and Fed rate hikes amid growth concerns has been the catalyst needed to expose the current market structure.
We find it ironic that over the past year we have found ourselves writing about either the lack of volatility or massive disjointed spikes in price moves. To us, this indicates that crowded trades, or herding has become the norm during periods when the put option offered by central banks is a widely-held view. Of course a turn in that view has led to the stampede mentality that we have witnessed during risk-off periods. Layering on the evolving liquidity dynamics created by greater regulation, more limited dealer balance sheets, and new investment vehicles exacerbates the volatility issues during stressed market periods. Finally, while we continue to debate the timing of Fed lift-off we are reminded that there is a natural tightening process underway as CB balance sheet holdings naturally roll-off and international reserve balances decline.
Most asset classes posted negative returns in August, although global equities have been the clear underperformer. The market volatility has driven U.S. stocks back to last fall’s levels, reversing the mostly flattish returns that they have posted for most of the year. With the S&P down 6% on a YTD basis, U.S. stocks remains the laggard amongst most of the developed markets. Recent losses have been most acute in the Asian markets however, as the regional impact of China’s policy woes has had a more direct impact on these exchanges.
A similar pattern has emerged in the currency markets, with the weakening USD vs most of the majors emerging since August driven by lower odds for a September rate hike. The largest moves have been in EM currencies however, with the 2.5% decline in CNY translating into 10+% falls in MYR and IDR. The resumption of falling oil and commodities has driven relatively large downward moves in the ZAR, AUD, and NZD, with the latter 2 currencies feeling the double whammy of China and lower commodities. We will note that while oil retested YTD lows, it has traded down 7% since the July FOMC meeting but is mostly unchanged since the CNY announcement.
From a rates perspective, the MOVE index has been the least volatile over the past month, with treasury yields marginally lower, but remaining within the post July FOMC range of 2.0% to 2.25%. The curve is also mostly flatter, as rate hike expectations has kept the short end within a fairly tight range. It is interesting to note that EGB yields were mostly higher during August.
Given global volatility and the decline in oil prices the odds of a September rate hike have declined significantly over the past few weeks. The futures market presently assigns just 35% odds that the FOMC will begin the liftoff process in September. Those odds increase to 61% in December, indicating that most investors still expect the Fed to act sometime this year. Fed speak continues to support the facade that many on the FOMC hope to be able to hike rates this year, with recent comments from Vice Chair Fischer, and regional Fed presidents Mester and Bullard indicating a continued desire to hike rates this year and possibly as early as September. Other commenters, however, have not been as forceful, with NY Fed President Dudley appearing much more on the fence after recent bouts of volatility, while Boston Fed’s Rosengren was neutral on September in our view. There is no press conference in October, and December risks include year-end influenced flows and the possibility for weather impacted data. Of course, Bernanke chose to begin the tapering process in December, 2013, after head-faking the market in September, so anything is possible.
What we do know is that there is limited data between now and the September 17th FOMC rate decision for the Fed to debate. We of course have the non-farm report this coming Friday, with consensus at +218 thousand, essentially unchanged from the prior month. It is worth noting that the survey week used for the upcoming report occurred on the week that China altered its FX policy, so any subsequent market induced volatility will not be captured in the employment data. Corresponding weekly claims data tells a similar story, with reported claims during the survey week remaining near the lows of the summer. Other data has also remained consistent with the moderate growth, stable consumer and muted inflation discussion that has been in place for the past several months. We therefore do not expect the data to provide much additional granularity for either the market or the Fed to chew upon, which makes market volatility the primary determinant for short term lift-off views. From this perspective, we suppose we will just have to wait and see, although lower equity prices (within reason) are not likely a major concern for the Chairman Yellen, who raised valuation flags earlier in the year. For our part, oil remains the key asset class in influencing the timing of lift-off, with stability at current or higher levels supporting an earlier move.