Uncertainty Causes Market Volatility

January 19, 2015

Uncertainty Causes Market Volatility Photo

Markets don't like uncertainty, and risk assets typically trade lower and volatility increases as uncertainty rises. This is the environment driving market action in 2015.

Last week was very active for the markets, as volatility increased to a new level. We expected the 10-Year Treasury to hold key support at 1.86%; however, the market traded below that level last week, as low as 1.70%. Other markets -- such as equities, commodities including oil, and currencies -- all experienced heightened volatility as well. So what drove this heightened uncertainty?

The market was caught off guard by the announcement that the Swiss National Bank (SNB) is no longer going to support the cap on the franc versus the euro. The abrupt and unexpected action by the SNB created a contagion effect that is beginning to impact firms across the globe. This action has heightened the markets sensitivity to the European Central Bank (ECB) meeting this week, where it is expected that a quantitative easing program will be announced.

We believe that the SNB announcement, along with the collapse in oil prices, will have lasting implications on the market. Additionally, record low interest rates around the globe continue to raise worries about a prolonged period of deflation. For example, if you buy a German 5-year bond for $1,000,000 today, at the end of five years you will have received total payments of approximately $998,500. You read that right. You actually need to pay to buy German bonds because interest rates are negative. Add to this the uncertainty with Fed policy, and we are in a volatile environment for the foreseeable future.

We still hold to our view that "Main Street will outperform Wall Street" in 2015, but we may see more negative pressure than we initially expected on asset prices. We have been concerned about liquidity in the markets, and the lack of liquidity will only exacerbate market moves in the near-term. We do expect the ECB to announce quantitative easing next week, but the key question remains: Will their action disappoint markets? We believe the market is set up to be disappointed.

Bottom line: Keep some money in reserves to take advantage of volatility. Look past the current instability to find assets with strong long-term fundamentals at a discounted price.

Tags: Monday Morning O'Malley | Interest Rate | Volatility | Germany | Deflation | 10-Year Treasury | 2015 Outlook | European Central Bank | Euro | Swiss National Bank (SNB)

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