Market Dynamics Are Changing. Caution Ahead!

May 28, 2015

Market Dynamics Are Changing. Caution Ahead! Photo

Over the last five years we have seen one of the greatest bull markets in history, as well as one of the worst periods for active managers. When everything is appreciating, investment skills may not be as important and caution is more of a drawback than a virtue.

However, all good things come to an end; recent market dynamics are showing signs that regime is slowly changing.

On the monetary policy front, comments from the Federal Reserve (Fed) have shown its strong intention to raise interest rates. Two quotes from Fed Chairman Janet Yellen's speech last Friday confirmed the Fed's intention:

My guess is that this apparent slowdown [in Q1] was largely the results of a variety of transitory factors that occurred at the same time….

Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner. [N.B., the Fed can't wait until 2% inflation to act.]

It is very hard to predict how the market will react when the Fed starts to withdraw liquidity. After almost a decade of financial repression, there are too many unknowns. I believe this is also why the Fed keeps emphasizing that the hiking path will be data dependent.

In the market, a lot of correlations are breaking down: Correlation between the U.S. dollar index and equities, correlation between yields and U.S. dollar index, correlation between equity and economic surprises, etc. I can't show all of them in this post, but feel free to email me for the charts.

This week's chart shows the divergence between asset volatilities. Volatilities for all major asset classes have been trending lower over the last five years and have stayed at a low level since late 2012. Since late 2014, volatility in currency and interest rates has increased, while equity volatility has stayed close to cycle lows.

Financial markets are fully connected nowadays, with global macro funds hunting alpha between different asset classes. This divergence between asset volatilities should only be temporary. Either the volatility for interest rates and currency will retreat, or equity volatility will pick up. I think greater volatility in equities is more likely because of the pending interest rate hikes.

Key Takeaways: A lot of market correlations are breaking down. The divergence of volatilities between different asset classes is one example of this breakdown. It is hard to predict how the markets will react to the Fed tightening. Use caution while sailing uncharted waters.

Tags: Chart of the Week | Market | Federal Reserve | Volatility | U.S. Dollar | Janet Yellen | Correlation

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