Wednesday 15 October saw a very volatile day in major world financial markets: the CBOE VIX index of implied equity volatility (Wall Street’s so-called fear gauge) jumped to 26, its highest intraday level since 2011, and well above an average of 14 over 2013. The level of US Treasury market volatility on that Wednesday has been seen in less than 1% of market trading days in the last 50 years. Throughout the day, US long-term interest rates lingered below 2%, while the 10-year German Bund yield fell to 0.74%. On average, US, Japanese and German sovereign long-term rates touched historic lows (trading below the levels seen at the height of the euro crisis in July 2012). Market pricing pushed back expectations of the Fed’s first rate hike by six months…
…all of this on a day of high trading volumes…
1) This day highlighted the interconnection of “investors – growth – central banks”:
- Investors are extremely dependent on injections of liquidity by central banks: the imminent completion of the Fed’s tapering (at the end of October) is making investors very nervous.
- The fraught and changing state of investor nerves poses a threat to global growth via repercussions on decisions regarding investment and consumption.
- Central banks will take these elements into account in their policy decisions: it is likely, in my view, that they will prolong their accommodative monetary policies.
2) What exactly happened on Wednesday 15 October?
There was a series of weak US data releases over the course of the day. None of the individual pieces of data were particularly important in themselves, but combined, they created a perfect storm in a market environment that was particularly ready for a tipping point, where equity markets have risen without a major correction for 18 months. Among the factors that weighed on markets were:
- The price of US benchmark crude oil slumped, falling to below USD 80/bbl for the first time since June 2012, extending a fall that began in June. Demand for oil has fallen on account of the slowdown in global growth.
- Data showed US retail sales fell by 0.3% in September.
- There were clashes between protesters and police in Hong Kong.
- A case of the Ebola virus was reported in the US.
- Uncertainty grew over the changing political situation in Greece.
- Chinese consumer prices rose at their slowest pace in almost five years in September
All of this came in the wake of the release, in previous days, of economic data suggesting that the German economy might be slipping into recession.
3) What’s next?
Surveys show that prior to 15 October, 80% of economists thought that the Fed would hike rates in September 2015. Post October 15, the number expecting a rate hike in September had fallen to 36%.
In my view, the consensus has overreacted. Barring some sort of financial accident, I expect the Fed to begin a new cycle of rate hikes in the second quarter of 2015. The US economy is improving and the extraordinary period of liquidity injections must come to an end…
The ECB, on the other hand, should get a move-on and implement full-scale quantitative easing. The 5-year, 5-year forward expected inflation rate (a key indicator selected by Mr Draghi as a measure of the effectiveness of the ECB’s action in maintaining expectations of inflation) fell to a low of 1.88%. The eurozone’s inflation rate is currently at 0.8% (compared with the ECB’s target of “close to, but below 2%”).
4) Oil geopolitics and its consequences
Since June, the price of US crude oil has dropped by USD 25/bbl, a 20% fall (see our interactive graph, below)
The principal consequences are:
- A boost to global economic growth
- Downward pressure on inflation
- Accentuation of the decline in interest rates
Paradoxically, neither the US nor Europe is happy about this decline in oil prices: it hinders the development of operations to exploit shale gas in the US (only 25% of shale gas holdings can compete with oil at USD 70/bbl) and in Europe, it aggravates the risk of deflation!
The forecast for global demand for oil in 2015 was recently revised down by 20% by the International Energy Agency. Saudi Arabia has nonetheless decided to lower its prices, preferring to safeguard its export volumes rather than preserving its unit margins.
No-one imagines, for a moment, that this policy is intended to weaken:
- Iran, a potential and real rival to Saudia Arabia’s leadership role in the Middle East
- Qatar, a financer of Islamic State
- Russia, in order to curry favour with the US
- The US, by reducing the competition from shale gas
The next OPEC meeting is scheduled for November.
5) Russia: geopolitical interests outweigh economic interests…for the time being, and probably up until the end of 2015!
Russia stands to be one of the losers of a sustained fall in oil prices.
To achieve a balanced budget, Russia needs an oil price of at least USD 104/bbl. For the time being, Russia can cope; with USD 450 billion of foreign exchange reserves, there is ample liquidity to pay down its maturing external debt, at least until the end of 2015…
6) And the winner is…India!
- Raw materials account for over half of the country’s imports and less than 10% of its exports
- India’s current account deficit is reduced by USD 1 bn for every one-dollar drop in the price of a barrel of oil.
- The budget deficit is improving through declining energy subsidies.
In 2015, Indian growth could actually exceed that of China!
The world is changing, and changing quickly…
Investors’ Corner articles related to market events on 15 October: