The balloon theory of volatility moving from one sector to another, from one asset class to another seems to be in play again with the USD and bonds on the front lines, writes Bob Savage, CEO of Track Research Sunday.
Just as balloons pop when there is too much air added, so too, they change shape when deflated and they reach a critical return to pressure.
Perhaps, the global economic inflation outlook is also changing like a balloon – and with it economic volatility.
The start of 2018 has turned from a bull run to a bear dance. The weekly move lower in equities was the worst in 2 years and for the blue-chip Dow Jones Industrial Average (DJI) the worst since 2008. While the equity market acceleration in the U.S. since November 2016 has led to $7.4 trillion in gains, this last week saw a loss of $1.25 trillion.
The blame for the turnabout according to financial analysts falls mostly on on interest rates both in the U.S. and globally. The central bankers are trying to regain their moral high ground as they remove the liquor from the easy money punch bowl.
Just the talk of removing QE in Europe has sent rates their up and as the FOMC remains on track for 3 hikes in 2018, so too U.S. rates are back towards 3% in 10-year.
But central bankers alone don’t drive markets, rather the role of fiscal deficits particularly in the U.S. drive up the cost of money and the doubt that growth alone can save the budgets planned. Others see the turn more about shaking out the weak hands of over enthusiastic investors, hitting all positions from commodities to bitcoins (BTC) to equities.
Perhaps the most important reason for the correction comes from the real economy where growth and inflation are beginning to look connected – particularly in the U.S. – where tighter labor markets drive up wages.
The fear of inflation destroying real demand returns and proves to central bankers that printing money still does work to offset deflation and prove Friedman right. The essential issue for the month has been set last week – is this a correction or a reversal of the bull market trend?
To be clear, we won’t know the answer in the week ahead, but we will get a better picture of the overall mood, a more complete list of drivers, and some further economic data.
The most interesting point about last week and price moves may be in the correlations shifting. U.S. dollar (USD/EUR) and rates rejoined while divergence in equities rolled towards one.
No one is so certain as they were in January or more accurately in 2017 as the central bank support process for financial stability is in doubt.
The mean reverting qualities of asset classes to each other – bonds to equities, forex and commodities – is in doubt thanks to leverage and years of QE, but perhaps those correlations are still in play as volatility across all markets returns to a more normal state.
The balloon theory of volatility moving from one sector to another, from one asset class to another seems to be in play again with the USD and bonds on the front lines.
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