By Christian Gattiker
February 13, 2018

Last week was an extremely volatile period for global markets, preceded by what many might have seen as a relatively calm and upbeat start to 2018. Approximately $5 trillion was wiped off the value of global equity markets from Feb. 1 to Feb. 9.

The turbulence started in the U.S. on Feb. 1 and continued throughout the following week. The Dow closed 10% lower on Feb. 9 than its Jan. 26 high. Similar slumps were also seen in the Asian market, with the Nikkei in Japan closing below 3% on Friday. The S&P 500, though ending Friday up 1.49%, still ended the week in official technical correction territory—defined as a decline of 10% or more from an index’s recent peak.

We are now seeing a yo-yo effect where U.S. yields go up while stocks go down, and U.S. yields go down while stocks go up. After 15 subsequent months of positive returns, the market has now started to price in the end of low and stable interest rates as inflation fears hit the market. That’s thanks to the U.S. Bureau of Labor Statistics’ recent announcement of strong labor market and wage growth data. The U.S. Federal Reserve has been sending messages of increasing volume to the market—interest rates will continue to rise and inflationary pressures will re-emerge as soon as economic activity and the domestic labor market strengthen. It expects inflation to further increase and stabilize around its 2% target over the medium term.

However, as with all market-intrinsic breakdowns, there is always a lack of empirical evidence. The intraday flash crash on May 6, 2010, which saw a 1,000-index point dive, is a perfect example. Academics are still trying to figure out the reason why markets tanked that day. The causes still remain elusive even after the resulting 200-plus page report.

Although the underlying cause of the recent volatility in the market is still not fully known, it is now widely believed that machine or algorithmic trading broadly contributed to the recent sell-off. This was amplified by the speed at which today’s trading platforms can run rules, make decisions, and perform trades. Although it is difficult to quantify the losses that were due to trades made by algos, many market observers say that the swift pace of loss may have encouraged more investors (human and artificial) to sell their shares and protect against further losses.

The volatility in the global markets will be a major test for the Fed’s new chair, Jerome Powell, and his chairmanship may well be defined by his first decision in office. Although it is believed that Powell will follow former Fed chair Janet Yellen’s footsteps with a gradual normalization of interest rates in 2018, there are several factors to watch, including: the impact of recent market volatility and whether this will impact Powell’s first meeting as Fed chair in March; whether the Fed will stay the course with Yellen’s plan to normalize rates; or whether it will blink and decide to keep rates where they are.

The wording of the Fed’s statement paves the way for further interest rate hikes in coming months and is aligned with the recent comments made by the governor of the Bank of England, Mark Carney. Carney has strongly hinted that rates in the U.K. will rise faster than anticipated, and to a somewhat greater extent in 2018, driven by encouraging economic growth, inflation, and higher global demand.

 

The narrative of volatility ‘shorties’ going into a death spiral, triggering an algorithmic trading reaction in equities, is as intuitive as it is logical. We doubt we will ever learn the real reasons and causes behind this month’s events.

This is far from what we would call a healthy market, but such are the risks investors always have to take. The question we hear investors asking themselves now is: Will it continue? We doubt it, as the excessive positioning took care of itself last week and, more importantly, the U.S. economy is strong. Evidence for this is that the usual go-to suspects are not performing at all lately: crisis assets, such as safe-haven bonds and gold, did not bounce during the stock market panic—and they always have when fundamental pain was just around the corner.

The ultimate takeaway is simple: There are dynamics in financial markets (and beyond) that cannot be grasped by anyone and remain intrinsic risks as in 1987, 1997, and 2010. We should now add 2018 to that list.

Christian Gattiker is chief strategist and head of research at Julius Baer in Zurich.

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