Eerie market calm could end with a bang
Forex markets continue to seesaw, Jellen prepares to speak in Jackson Hole, Trump and Clinton square up at the polls – these and other uncertainties still require extra vigilance
During the dog days of summer, trading volumes in stock markets are thin as investors head for the beaches to clear their heads.
Yet even by the standards of summer lulls, the current calm in markets is remarkable, particularly given the plethora of risk and vulnerabilities facing the global economy.
The facts speak for themselves.
The yield on benchmark 10-year US Treasury bonds has been trading in a narrow range of 1.4 per cent to 1.6 per cent since mid-July while the Vix Index – a measure of the implied expected volatility of US equities commonly known as Wall Street’s “fear gauge” – has barely budged since the beginning of last month and currently stands at 13, just slightly above its pre-2008 financial crisis low of 10.
The S&P 500 equity index, meanwhile, which on Wednesday closed just 0.7 per cent below its all-time high set on August 15, has been range-bound since early July and currently stands just 175 basis points above the level it fell to just after Britain’s shock decision on June 23 to vote to leave the European Union (EU).
Even the Vstoxx, the European equivalent of the Vix index, has fallen to below 20, down from 40 just before the Brexit vote and only slightly above its lowest level over the past five years.
Make no mistake, volatility levels in the equity and bond markets have collapsed as investors become more confident that global interest rates will remain lower for longer amid hints from leading central banks, in particular Japan’s, that more stimulus measures may be forthcoming.
Yet beneath the surface of market calm, there is mounting uncertainty about the outlook for the global economy and the sustainability of a rally that stems almost entirely from liquidity support from central banks.
The most conspicuous sign of nervousness is in the foreign exchange markets which have been anything but calm this year.
The yen, Japan’s currency, has strengthened a further 6.3 per cent against the dollar in the last month and is now hovering near the psychologically important level of ¥100 to the greenback. The euro has also shot up since mid-July, strengthening 6.5 per cent against the dollar.
Yet further appreciation of the yen and the euro – a major concern for both the Bank of Japan (BoJ) and the European Central Bank (ECB) whose aggressive quantitative easing (QE) programmes are supposed to engender currency weakness – is by no means assured, as the odds of another US interest rate hike later this year increase.
All eyes are on Federal Reserve chair Janet Yellen’s much-anticipated speech at the annual monetary policy symposium in Jackson Hole, Wyoming on Friday in which she may echo recent hawkish comments from other Fed policymakers.
The dollar enjoyed its fourth straight day of gains on Wednesday as the probability of a rate hike next month increased to nearly 30 per cent (and more than 50 per cent in December).
If Yellen strikes a hawkish tone on Friday, emerging market (EM) assets and commodities – already under strain this week – could come under pressure.
A dovish speech, however, would lift the yen, increasing the likelihood of intervention by Japanese policymakers to weaken the currency.
Either way, currency markets could become even more volatile in September, boding ill for broader sentiment.
The other two big risks which could put an end to the period of market calm are the momentous US presidential elections in November and renewed tensions in Europe, particularly in Italy.
It is striking that equity and bond markets remain so calm just 11 weeks before Donald Trump, the anti-establishment Republican presidential candidate, may become president.
Even though Hillary Clinton, his Democratic opponent, has pulled ahead in the polls and is now the clear favourite to win the race, there is an inescapable feeling that “Trump risk” is still being underpriced.
Meanwhile, another pivotal national referendum in Europe looms as Italy’s premier, Matteo Renzi, stakes his political future on a plebiscite on constitutional reforms in November. If he loses the vote – the latest polls suggest there is a good chance he will – Italy could be plunged into a political crisis which, inevitably, would put its creaking banking sector under yet more strain, potentially leading to renewed tensions across the eurozone.
Still, if even the UK’s decision to leave the EU only caused global markets to sell off for a few days, it is not surprising that investors have become complacent.
Yet it is precisely when complacency reigns that extra vigilance is required.
Nicholas Spiro is a partner of Lauressa Advisory