Volatility is Back
15 Pages Posted: 13 Mar 2018
Date Written: March 11, 2018
Stock markets across the globe underwent a sharp correction in late January and early February. After a steady rally that had lasted several months, capped by the strongest January since the 1990s, the release of a labour market report showing higher than expected US wage growth heralded a burst of heightened activity. Equity valuations fell, rebounded and fell again, amid unusual levels of intraday volatility. This correction coincided with higher volatility in government bond markets. Long-term Treasury yields had been gradually rising since mid-December, as investors seemed increasingly concerned about inflation risks as well as the macroeconomic impact of US tax reform. A sudden spurt in yields at the very end of January preceded the stock market drop in the United States and subsequently in other advanced economies (AEs). Government bond yields also increased in several other AEs, as the synchronised upswing in global growth led investors to price in a less gradual than previously expected exit from unconventional policies.
Throughout the period under review, which started in late November, market participants remained very sensitive to any perceived changes in central banks’ messages. As expected, the Federal Reserve raised the federal funds target range by 25 basis points in December, and its balance sheet reduction moved forward largely as planned. Across the Atlantic, the ECB maintained its policy stance and left its forward guidance unaltered, including an open-ended date for the termination of its asset purchase programme (APP). The Bank of Japan responded to an uptick in longterm yields, which appeared to test its yield curve control policy, with an offer to buy an unlimited amount of long-term government bonds.
The market tremors occurred within a general context of protracted US dollar weakness for most of the period, continued loosening of credit conditions, and undaunted risk-taking in most asset classes. A brief flight-to-safety event associated with the peak of the stock market turbulence provided only limited support for the dollar. Neither the Fed’s steady tightening nor the recent equity sell-off coincided with wider corporate credit spreads, which remained at record lows. The appetite for emerging market economy (EME) assets also stayed strong. Stock markets soon stabilised and trimmed their losses. At the same time, bond investors appeared to struggle in assessing the overall impact of an evolving inflationary outlook and the uncertain size of the future net supply of securities with longer tenors.
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