This article on the recent turmoil in financial markets was written on 5 February 2016 in New York City.
The first month and a week of 2016 has been a bloodbath with sharply wider spreads in fixed-income risk assets and steep drops in equity markets. Year-to-date excess returns are largely negative for US investment-grade (IG) bonds at -2.63%, US high-yield (HY) at -4.84%, and US mortgage-backed securities (MBS) at -0.64%. Volatility is up, bond markets are rallying and negative interest rates are prevailing in developed markets. Investors are questioning the extent to which central bank policies can support financial asset prices.
The strong correlation between oil prices and the prices of risk assets is unsettling. The carnage suggests that valuations are being driven by pressing liquidity needs and not by underlying asset fundamentals. But as we know, the market always has the last word on valuation and, for now, that means we set aside the fundamentals. We need to show some respect for the technical nature of the current trading environment.
Economic data releases in the first week of February were mixed with a steady reading on ISM manufacturing at 48.2 and an ok reading on ISM Non-manufacturing at 53.2. We also received positive news on US auto sales but have also seen a recent rise in initial jobless claims up to 285,000 in the most recent week.
The non-farm payroll report was also mixed. The US economy added 151,000 jobs in January, which was a little weaker than consensus estimates. However, the unemployment rate fell to 4.9%, dropping below 5.0% for the first time since early 2008. And there was better news in the increase in average hourly earnings up 0.5% over December and up 2.5% year-on-year. There also was an increase in the work week to 34.6 hours. It would appear that labor market slack continues to subside and that wage inflation pressures are building.
Exhibit 1: US average hourly earnings year-on-year % change
On the 28 January , the Bank of Japan surprised those who may have thought that the race to the bottom in the developed markets (DM) currency war would be an orderly one by moving to negative interest rates. Comments from Federal Reserve (Fed) officials, in the week ending 05/02/16, show that the US is not entirely ready to pass the baton over to others. Fed Vice Chairman Stanley Fischer, only a few weeks ago, was certain that there would be four rate hikes in 2016. In his speech on 1 February, he reiterated that monetary policy remains accommodative even after the December hike. Additionally, the federal funds rate is likely to remain low for some time and below levels expected to prevail over the long run.
Vice Chairman Dudley has recently highlighted how much tighter financial conditions are today than they were when the Fed voted to hike the funds rate in December. In the statement released on 27 January, the Fed cited concerns about global economic and financial developments. Since that time, credit spreads have continued to move wider and equity markets have continued to move lower. The one respite is that the dollar has reversed its ascent against the euro and the yen.
It would seem that bond investors have less uncertainty about policy rates than the Fed. The market is pricing for a pause in the hiking cycle and, in fact, Fed fund futures imply no additional rate hike for 2016. Market pricing also suggests a much lower terminal value for the Fed funds rate. Bond markets are clearly assigning a greater probability to a recession in the next 12 months than is the Fed. Financial market volatility is likely with us for a while.