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Current High Volatility Regime Will Likely Persist

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Other Signs Pointing to Market Volatility

The combination of slower global growth, uncertainty as to the Federal Reserve (or Fed)’s future path and less benign credit market conditions suggests continued heightened volatility.

In addition, Washington may also fuel volatility in the coming week. Congress needs to pass a continuing resolution by September 30th to keep the government funded and avoid yet another government shutdown. While I don’t expect a shutdown, the risk of that scenario increased somewhat Friday following the announcement that House Speaker John Boehner will resign from Congress at the end of October.

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Market Realist – The high volatility regime will likely be the norm in the future.

As reported by Reuters, an analysis by State Street observed that the US market has already clocked 42 highly volatile days in 2015. These days charted volatility in the top 10% of all observations in the past five years. This marks a sharp rise over last year where only 11 days were classified as highly volatile. We believe that this high volatility regime will likely persist going forward.

High Volatility Regime

The Fed would continue to be a source of volatility (VIXY) for the markets until the timing of policy normalization becomes clear. Although Fed Chair Janet Yellen stated that a rate hike could come later this year, uncertainty persists. The possible effects of the Chinese slowdown on the global economy remain unclear. This is adding to the uncertainty. Also, inflation is still way below Fed’s target of 2%. The Fed stated that this was a primary factor that influenced the decision to postpone the rate hike in September. The above graph shows how four of the 17 FOMC (Federal Open Market Committee) members aren’t inclined to hike the rates in 2015.

High Volatility Regime

The above graph shows how the market’s inflation expectations are still weak. The break-even inflation rates are often considered to be the gauge for the market’s inflation expectations. The fall in the inflation expectations can be attributed to the fall in crude oil (USO) (BNO) and commodity prices.

High Volatility Regime

The financial conditions have also changed. Credit spreads have been widening over the past few weeks. The above graph shows the BofA Merrill Lynch U.S. Corporate BBB option-adjusted spread. It shows the spreads between Treasuries (TLT) and corporate bonds (AGG). The BofA Merrill Lynch U.S. High Yield B option-adjusted spread observes the spreads between Treasuries and high-yield bonds (HYG) (JNK). As reported by The Economist, the distress ratio—the proportion of high-yield bonds with spreads over ten percentage points—has risen to a four-year high of 15.70%. Energy companies (IYE) (VDE) account for more than 15% of the junk bond markets. The oil price retreats are shaking the confidence of high-yield investors. Widening credit spreads signal higher risks and lower investor appetites.

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