Get The Ticker Tape delivered right to your inbox.

X

Fed’s Move to ‘Normal' May Invite Unusual Market Volatility

Share Print
December 3, 2015

A majority on Wall Street has gotten used to the idea that the Federal Reserve could nudge U.S. interest rates higher mid-month for the first time in nearly a decade. Less clear is how financial markets could react in coming weeks and months as the expected gap between U.S. monetary policy and that in Europe and elsewhere likely widens.

That gully has serious implications for dollar strength, global economic stability, and stock and bond markets.

As for U.S. stock volatility, demand for futures on the CBOE Volatility Index (VIX)—which tracks the implied volatility priced into short-term SPX options and is often called the market’s “fear gauge”—is on the rise. A quick glance at the VIX futures pricing chart shows volatility expectations rising during the week of the Fed’s December 15-16 meeting. That week includes the potential added volatility of “quadruple witching” expiration, notes JJ Kinahan, chief strategist with TD Ameritrade. Witching marks the expiration of futures and futures options on top of stock and index options. That means the big firms with market muscle may have to unwind positions and the net result might be a bit more trading activity. Higher VIX futures demand is evidence of some traders’ willingness to pay up for a degree of short-term protection during such a potentially pivotal week. Of course, VIX itself remains near 15 (figure 1), well off the 20 mark that typically flips on the “worry” switch in the stock market.

VIX stock volatility

FIGURE 1: CHURNING NEAR RECENT LOWS.

The CBOE Volatility Index (VIX), charted on the thinkorswim® platform, has traded near 15 as stock indexes logged modest gains so far in anticipation of as-expected Fed moves. Data source: Standard & Poor’s. For illustrative purposes only. Past performance does not guarantee future results.

Do Markets Reflect Full Spectrum of Change?

Short-term Fed funds futures market traders have priced in a 75% chance that the Fed activates the first interest rate hike since 2006 when it wraps a two-day session on December 16. That’s according to pricing calculations provided on the CME Group’s FedWatch Tool. In fact, it’s the relative stability of these expectations that brought short-term relief to a stock market that previously bristled at the thought of losing such easy lending accommodation. The stock market has moved gradually higher in the weeks leading up to the mid-December meeting, as have Treasury yields (they move opposite of bond prices).

“Yields on the short of end of the curve, which are most sensitive to a rate hike, have risen pretty significantly since the end of October when Fed members began messaging the markets that a hike prior to year-end was a possibility,” says Craig Laffman, director—fixed income trading and syndicate, with TD Ameritrade. 

The yield on the one- and two-year Treasury notes have moved 22 and 26 basis points, respectively, since October 27 and have hit close to four-year highs. Historically, these are dramatic moves from a percentage standpoint.

“It appears at least for the time being that the bond market believes the Fed will hike in December,” says Laffman. “Expect additional volatility as the longer-term strategy around future hikes is flushed out.” 

The Fed itself has already cracked the policy door open. Speaking on December 2, Fed Chair Janet Yellen stopped short of promising a hike but said she expects the U.S. economy to churn higher at a growth rate that will tip inflation back up to the central bank’s 2% annual target. Holding rates at its current level near zero also risks “excessive risk-taking” by investors, Yellen noted. Other top Fed officials such as Dennis Lockhart and Lael Brainard sent signals in their recent speeches of readiness to raise interest rates.

Global Ripples

But clearly the Fed can’t totally ignore global happenings. Many Street economists think the Fed was ready to move in September if it weren’t for the China-triggered global pullback.

At the same time that the Fed is shifting its view, the European Central Bank again lowered select interest rates, while buying more bonds. The extra stimulus there could push the value of the dollar even higher and add more pain for American exporters, who’ve already listed dollar brawn in earnings warnings.

And, because the dollar is used as a reserve currency, a rapid rise in its value could put pressure on emerging markets in particular, especially if they’ve borrowed overwhelmingly in dollars but create only limited dollar earnings.

There’s more, strong interest rate and currency moves can force stock portfolio unwinding due to regulatory controls. Ripples can move through the broader market as a result.

All told, financial markets appear to have settled on the idea of higher U.S. interest rates but are they comfortable with the collateral effects that could come with such a move?