LONDON – An almost eerie period of low financial market volatility appears to be ending as the exceptional U.S. economic expansion re-ignites the dollar and bond yields worldwide just as geopolitics worsen, emerging markets struggle and stocks wobble.
While there are good reasons to cheer the sheer resilience of the biggest economy in the world, the pivotal role of the dollar and U.S. Treasury borrowing benchmarks means continued U.S. divergence from the rest spells financial turbulence ahead.
With U.S. first-quarter growth now penciled in close to 3%, retail sales still roaring through March and inflation and inflation expectations stuck above 3%, the Federal Reserve will find it hard to cut interest rates at all this year even as peers in other major economies feel pressured to ease soon.
After a series of similar soundings from his colleagues over the past week, Fed Chair Jerome Powell set the tone late on Tuesday by bemoaning the lack of progress on disinflation as the U.S. economy stays strong and said restrictive policy needs more time to work.
While the International Monetary Fund has over the past six months nudged up its 2024 world growth forecast by 0.3 percentage point to 3.2%, it’s dramatically raised its U.S. growth call by 1.2 points to 2.7% over the same period. The outlooks for all the rest of the G7 have been downgraded in that time and even projected growth in emerging markets at large was only lifted by 0.2 point.
Add investor anxiety over heightened Middle East tensions and U.S. election uncertainty a little over six months away and you have a potential tinder box in markets.
With the dollar’s long-presumed decline on the back of Fed rate cuts now cast aside and the greenback’s main traded index surging to 2024 highs, previously serene gauges of implied currency volatility ahead have reared up this week.
The CVIX index jumped from two-year lows last month to its highest level in two months this week as the Fed calculus shifted, the European Central Bank appeared to double down on a June rate cut and Japan’s yen plummeted to 34-year lows – seeding competitive pressures across Asia’s exporting nations.
Pressure on China to lean on exports again as its domestic demand recovery continues to be dogged by an ongoing property bust has opened up cracks in the yuan too.
Bond markets have already been coping with elevated volatility since the inflation and interest rate spikes of 2022. But hopes of a return to more “normal” Treasury market swings also have been bamboozled by the U.S. and Fed rethink.
The MOVE index of implied Treasury volatility had subsided to its long-term average only last month – less than half the levels seen during the banking disturbances last year. But it too has jumped by a third this month to hit its highest level since the start of year.
A series of U.S. consumer price inflation misses since the turn of the year and the shift in Fed rhetoric have spurred 10-year Treasury yields back up to 4.70% for the first time since the October bond blowout last year.
Long-term market inflation expectations, captured by the 5-year, 5-year forward inflation-linked swap, have jumped a quarter of a percentage point to almost six-month highs of 2.75% – far above the Fed’s 2% target.
So-called long-duration bonds have been battered and exchange-trade funds tracking 20- and 30-year Treasuries are now down more than 10% for the year to date – having lost a whopping nearly 40% in a little over two years.
BONDS BAMBOOZLED
And the scale of the withdrawal from bonds was evident in the latest global fund manager survey from Bank of America.
The poll showed a massive 20-percentage-point drop in overall allocations to bonds this month – the biggest monthly fall since 2003 and leaving asset managers registering a net underweight position of 14%. The share of funds expecting bond yields to fall over the next 12 months has been almost halved to just 38% since the start of the year.
Despite the more dovish take on interest rates from central banks in Europe and elsewhere – amid softer growth and inflation readouts there – the Treasury yield resurgence has still hauled up sovereign yields everywhere in its slipstream.
The heft of Treasuries in global bond portfolios is at least partly to blame.
But as all debt markets are re-pricing again to reflect the absence of a global recession on the medium-term horizon – and the IMF’s latest forecasts on Tuesday showed modest 3%-plus world growth rates right out through 2029 – all long-term debt is forced to find a new level.
Even though more speculative corporate “junk” bond prices have been hit too, the absence of a recessionary red flag means the borrowing premium on U.S. junk yields over Treasuries remains under wraps at its smallest in two years.
But for developing economies with heavy borrowing in dollars, the combination of climbing Treasury yields and renewed dollar strength spells trouble again.
For pricey equity markets that should on balance benefit from the pumped-up growth outlook, the more turbulent rates world is taking its toll.
Add to that the restive political backdrops and the prospect of the weeks or months of nervy weekends surrounding the Israel-Iran standoff, and the “risk-off” mood has stirred volatility there too.
The “fear index” of S&P 500 implied volatility had remained depressed during a bumper first quarter for U.S. stocks – but it has re-awakened too this week and hit its highest level in more than five months. Touching its 35-year average just under 20, the index has ended the week below that in all but two weeks since the regional bank fracas last year – and those two weeks were during the bond ructions of October.
Volatility uncorked across the world? It may be a very bumpy ride for investors through the summer.
The opinions expressed here are those of the author, a columnist for Reuters.
