The Demise of Disorderly Markets: A Macro Perspective
At the start of 2018, markets appeared to tumble into chaos. Taking a step back, though, the bigger picture may actually be settling – a reflection of robust investor confidence and strong market fundamentals.
Financial market disorderliness can occur swiftly and without warning, shocking investors with extreme volatility, market illiquidity and lost valuations. Such an episode took place early in 2018 as a surprising economic statistic led to disruptions and investors ran for cover. As volatility spiked upward, valuations crashed and surged, crashed and surged in multiple markets over several days and among multiple asset classes. Two-way risk replaced the relative calm of one-way markets that had prevailed for years.
The good news: soon after, all classes recomposed, buoyed by confidence and strong market fundamentals. Almost on cue, volatility that had spiked began to drift down toward, and even below, its long-term average level. Counterparties reappeared and largely restored market liquidity, making price discovery possible once again. Fixed-income security prices and yields fluctuated, rising during some hours and days, falling during others. Later announcements of macroeconomic data, pronouncements by government and Federal Reserve officials, geopolitical developments and news about individual companies elicited nearly automatic responses followed by vigilant calm.
The 2018 financial shock was not an isolated event. Since the financial crisis ten years earlier, US markets have experienced more than 100 episodes of volatility spikes and the periodic disappearance of market liquidity. Almost all of these episodes, however, were very brief, before volatility returned to previous levels.
Yet investors and speculators cannot unhear what they heard or unsee what they saw. The events of January and February of this year will change the path of asset allocation decisions, as well as how market participants trade. Investors and speculators can no longer feel imperious to the risks that come from complacency, extrapolation of trends or exuberance over past gains.
The demise of disorderly markets emanates from high conviction in economic, policy and market fundamentals among investors and speculators. More than likely, these market participants acted with confidence that inflation and long-term interest rates, while likely to edge higher over time, would not increase dramatically. The following support this conviction:
Credible, long-term commitment by the Federal Reserve to fulfill its mandate to bring about price stability.
Continued projections by the Fed anticipating gradual increases in inflation through 2021.
Transparent monetary policy restraining term premiums built into long-term interest rates.
Lack of evidence that the US economy will soon over-heat, necessitating more rapid increases in monetary policy tightening.
Strong demand for US Treasury securities even as the budget deficit – and debt – promise sizeable expansions.
Long-term structural and secular trends that tend to be disinflationary like an aging population, massive technological change and strengthening sustainability initiatives.
In the end, the demise of market disorderliness reminds investors that markets can go two ways – down as well as up – but adherence to fundamentals when making trading decisions leads to the best long-term results. That means staying in the market even when it is most turbulent while also avoiding extrapolation of trends exuberantly, especially when market conditions have begun to change.
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Multiple Factors Hint at Continued Status Quo from ECB
Even though the ECB’s monetary policy has been very accommodative, its plans for dialling it back have been quite conservative. We don’t expect this will change at the central bank’s next meeting. QE will eventually end and short-term rates will eventually rise – but not yet.