Last week a branch snapped in the forest… waking the hibernating volatility bear. Jumping to all fours, teeth bared, ready to attack. The groggy bear surveyed the landscape, listening intently while sniffing the air for even the slightest scent of trouble. Carefully camouflaged under promises of tax reform, deregulation and fiscal stimulus the volatility bear detected nothing amiss in the wide gap between investors’ expectations and actual hard economic data. He shrugged, walked in a circle, flopped back down on the ground, yawned and went back to sleep… extending what is becoming a historically long winter nap. Some day he will wake, but it was not to be last week. On Wednesday, when the branch snapped, equities suffered their worst one-day loss since BREXIT with the S&P falling 1.8% and global equities declining 1.2%. The VIX Index (a measure of expected market volatility) jumped 46% to 15.59, albeit off a low base of 10.65 the day before. The next day equities resumed rally mode, recovering much of the losses and ended the week with a modest decline of less than 1%. The VIX Index promptly fell back to 12.04, a value that is well below the post-Financial Crisis average of 17.6 and the longer-term average of 20.
Looking beyond the fireworks of the stock market, the bond market may be sending a clearer signal. The U.S. Treasury Yield curve flattened further last week as the yield on the 10-year declined by 9bps (0.09%), while the 2-year note yield fell only 2bps. At 96bps, the spread between the 10-year and 2-year notes is now back to about where it was prior to the Presidential election. Historically, a flattening yield curve indicates the market expects lower growth, interest rates and inflation.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Best Laid Plans: When the Federal Reserve raised interest rates in December 2016 and then again in March 2017 it served two purposes:
- Initiated the rate normalization process. The Fed’s hope/forecast is to raise short-term rates to 3% so that they will have “dry powder” for the next recession.
- Tightened monetary policy to temper what the Fed views as potentially building sources of inflationary pressures in the economy. The Fed is especially concerned about the low and falling unemployment rate, which they fear will generate wage-push inflation resulting from an overly tight labor market.
This is standard monetary policy strategy – tighten when the Fed believes the economy is on a path toward overheating and loosen when the economy is flagging. Yet a funny thing happened on the way to tightening monetary policy…. measurements of financial conditions in the U.S. have become easier, not harder, frustrating the Fed’s efforts.