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Is Heightened Market Volatility Here to Stay?

As major equity indices briefly entered correction territory last week – with the Dow Jones Industrial Average falling by over 1100 points in one day on February 5th, its largest single-day drop ever – volatility came roaring back into the markets after an unusually quiet and complacent 2017. While last week’s overall pullback in global stock markets was far from disastrous when viewed from a longer-term perspective, however, the disproportionate rise in market volatility was nothing short of extreme.

Massive Volatility Spike

The VIX (often referred to as the “Fear Gauge”), a popular index measuring volatility in the S&P 500, spiked rapidly within two days from under 20 to a brief peak slightly above 50, its highest level since August of 2015. As is characteristic of market volatility, the VIX quickly dropped back down to much more reasonable levels, but significant damage had already been done.

Sharply elevated fear and confusion swiftly gripped the markets, resulting in vast and wild swings for major equity indexes in subsequent trading days. Along the way, exchange-traded funds and trading algorithms based on volatility saw violent, and sometimes catastrophic, swings – particularly for those positioned on the short side of volatility. The dramatic unwinding of this long-overcrowded short-volatility trade helped to exacerbate the sharp surge in volatility, contributing even more to market fear and instability.

Volatility Triggers

While this unwinding of the short-volatility trade can be blamed for some of the stock market drop and most of the tremendous surge in volatility, there are also other key reasons for the equity pullback. Firstly, market uncertainty had already been building for months as stocks continued to reach progressively higher all-time highs, sometimes on a daily basis, with hardly any interruption or pullback.

Perhaps more importantly, market concerns have increased abruptly in the past couple of weeks regarding rising inflation and interest rate expectations as signaled by surging government bond yields, most notably in the US. US Treasury yields have recently risen to and remained elevated near multi-year highs. In addition, rising wage growth as detailed in January’s US jobs report, released a little more than a week ago, reinforced those concerns.

Exacerbating interest rate worries on a global basis, the Bank of England issued a warning last week that rates in the UK may increase more quickly than expected. When combined with other major central banks that are seen as actively moving towards policy tightening, including the US Federal Reserve and European Central Bank, that signal from the BoE further supported market expectations that the end of easy monetary policy on a global scale is likely impending, placing further pressure on equity markets as well as sparking substantial currency moves.

What Comes Next?

Late last week and early into this week, markets have seemed to calm down somewhat, as major stock indexes, including the Dow Jones Industrial Average and S&P 500, have staged significant rebounds thus far, paring some of last week’s losses (though US equity markets were modestly down again as of this writing early Tuesday). In addition, although it is still elevated, market volatility has further contracted from last week’s extreme highs. The question now is whether volatility will continue to calm down to more typical levels or if it will remain elevated, characterized by wild swings, as the dual specters of rising inflation and interest rates still loom.

While extreme levels of volatility like those seen last week have historically proven to be unsustainable, a generally higher plateau of volatility than what was seen during the prolonged complacency of 2017 is highly likely going forward. This could very well mean that there will be many more two-way market movements ahead, as opposed to last year’s prolonged periods of unidirectionally bullish moves in the equity markets. This could likely be the case even though the long-term bull market remains strong and intact, at least for the time being.

Of immediate concern for equities, currencies, and gold prices is this week’s release of key inflation indicators, most notably from the US. Wednesday brings the US Consumer Price Index (CPI) for January, a major consumer inflation indicator. The headline CPI is expected to have risen by 0.3%, significantly greater than the previous month’s 0.1%. The core CPI, which excludes food and energy items, is expected to have risen by 0.2%, a notch lower than the previous month’s higher-than-expected 0.3% rise. The US Producer Price Index for January, another key inflation indicator, will subsequently be released on Thursday.

Amid the release of these important inflation figures, market uncertainty and volatility continue for now. And more likely than not, this heightened volatility will be around for significantly longer as markets come to terms with rising interest rates and the end of loose monetary policy on a global scale.

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