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Markets Should Embrace Volatility While It Lasts

Robert Burgess
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Markets Should Embrace Volatility While It Lasts

(Bloomberg Opinion) -- It sounds simple. Buy stocks when there’s news that the U.S. and China are making headway in resolving the escalating trade war. Sell them when the divide seems to be growing. But the problem for markets these days is that it appears as if every positive development seems to be followed closely by a negative one, sometimes within hours, and investors are having a hard time keeping up with the rapid-fire developments.

That can be seen in the 910-point swing between the Dow Jones Industrial Average’s low Monday and its high on Tuesday before ending little changed. To recap, stocks were weighed down early Monday after news broke over the weekend that China summoned U.S. Ambassador Terry Branstad to explain the U.S. request to extradite Huawei Technologies Co. Chief Financial Officer Meng Wanzhou from Canada, where she is being held. Stocks then opened big on Tuesday on the news that U.S. and China officials held a call to discuss trade, followed by a Bloomberg News report that China is mulling a proposal to reduce tariffs on cars made in the U.S. to 15 percent from the current 40 percent — bringing the U.S. back in line with what other countries pay. Progress, right? Alas, the gains turned to losses as the Washington Post reported that the Trump administration is preparing a series of actions this week to call out Beijing for what it says are China’s continued efforts to steal U.S. trade secrets and advanced technologies and compromise sensitive government and corporate computers. (Full disclosure: That was also around the time President Donald Trump said he would be “proud” to shut down the U.S. government if his demands for border security funding aren’t met.) The upshot is that realized volatility is rising at a pace only truly seen twice before in the last five years, once in early February and again in August 2015 during the China growth scare.

The good news is the U.S. stock market recovered rather quickly both times, and traders don’t expect volatility to get much worse from here. The ratio between current volatility as measured by the CBOE Volatility Index, or VIX, and the CBOE VVIX Index, which is the implied volatility of the VIX, has dropped to the lowest since February 2016. Of course, that doesn’t mean stocks are done falling, but perhaps it may mean that the ride will be a little less bumpy. The flip side is that the opportunity for traders to make money tends to rise along with volatility. Take your pick. 

LIQUIDITY IS BEING HAMPEREDOne of the negative byproducts of rising volatility is that it tends to dampen liquidity, which then tends to exacerbate market moves and add to volatility in a sort of unvirtuous circle. The Bank of America Merrill Lynch Liquidity Risk index has jumped to its highest since March 2017, reaching a level of 0.47 on Tuesday. Levels greater than zero indicate more stress than normal, while readings below that indicate the opposite. The reasons for the deterioration of market liquidity vary, but the Federal Reserve is a prime culprit. There wasn’t a whole lot of concern about liquidity when the central bank was pumping money into the financial system through its bond purchases. That policy of quantitative easing pushed the Fed’s balance sheet assets from less than $2 trillion in 2009 to as high as $4.52 trillion in 2015. But this year, the Fed has been allowing some of those assets to mature and is not reinvesting the proceeds back into the market. As a result, its assets have shrunk by about $400 billion this year to $4.09 trillion. If you believed the Fed’s purchases helped financial assets, then it makes sense that those same assets would be hurt as the central bank unwinds those purchases.

SLEEP IS OVERRATEDThe volatility in equities has nothing on natural gas, where the 30-day historical volatility has just matched its highest level since 2009. After trading in a range of about $2.50 and $3.25 per million BTUs since February, the natural gas market started going bonkers in early November, rising to almost $5 per million BTUs. Market participants now say the move was probably sparked by a hedge fund that had to unwind some huge bets on higher oil and lower natural gas prices after crude started to collapse. The impact is still being felt, with traders saying they are often up around the clock to monitor the moves, according to Bloomberg News’s Naureen S. Malik. “This is a 23-hour-a-day market now, and you have to be on top of it,” John Kilduff, a partner at hedge fund Again Capital LLC, told Malik. With natural gas increasingly seen as a cleaner alternative than coal at a time of global warming, trading volume of benchmark U.S. natural gas futures is up 15 percent in Asia and 25 percent in Europe. Whereas moves of a nickel or a dime were considered sizable just a few months ago, daily swings are likely to stick around the 30- to 35-cent range for a while this winter, Kyle Cooper, a Houston-based consultant at Ion Energy Group LLC, told Malik.

VOLATILITY STRIKES THE YUANChina’s currency is closely controlled by the government, which allows the yuan to move no more than 2 percent on either side of its daily fixing rate against the dollar. But that doesn’t mean that trading in the yuan can’t get volatile, relatively speaking. The currency’s 10-day volatility surged above 8 percent Monday, the highest level since August 2015, according to Bloomberg News’s Sofia Horta e Costa. The wild trading contrasts with the calm that descended on Chinese financial assets just a few weeks ago, before Trump’s meeting with Xi Jinping triggered the yuan’s biggest two-day gain in more than a decade. The jump in volatility signals that optimism may be quickly fading that the 90-day truce reached in Buenos Aires will ease tensions between the world’s two largest economies after the U.S. requested the arrest of Huawei’s CFO. Further weakness in the currency may reignite concern it will fall past the key 7-per-dollar level for the first time in a decade, a level that some investors and strategists are concerned could spark a flight of capital from China and through global markets. The big swings in the yuan contrast with the rest of the global foreign-exchange market, where the JPMorgan Global FX Volatility Index is comfortably below its highs of the year and has traded in a relatively tight range since early 2017.

BONDS SEND MIXED MESSAGEFor all the talk about the Fed possibly being close to ending its interest-rate hiking cycle and Trump threatening to shut down the government over his demands for border wall funding, demand at Tuesday’s U.S. government auction of $38 billion in three-year notes was rather ordinary. Investors placed bids for 2.59 times the amount offered, below the average of 2.75 for that maturity this year. Shorter-dated notes should stand to benefit if bond traders really believed that the Fed will only raise rates once more this year and perhaps one more time in 2019, instead of the three to four times the central bank has forecast. “The lack of any strong demand for U.S. Treasury auctions has been an important characteristic all year,” Bleakley Financial Group chief investment officer Peter Boockvar wrote in a note to clients Tuesday. At this auction, “Buyers dealt with maybe two conflicting thoughts. On one hand, the Fed is maybe one and done with more rate hikes — even though they desperately want to get (the federal funds rate) to 3 (percent), thus making this (three-year note) more attractive. On the other hand, the yield is the lowest in three months, thus maybe lessening the demand.”

TEA LEAVESGiven how turbulent markets have been of late, there’s been some whispering among market participants that if Wednesday’s Consumer Price Index report is bad enough, it just might prompt the Fed to not raise interest rates when policy makers meet next week. That’s beyond wishful thinking. Although the headline number is forecast to show no change for November, compared with October’s 0.3 percent increase, largely because of a drop in gasoline prices, the more important core number that strips out volatile food and energy prices is seen advancing at a more normal 0.2 percent. That would push the annual rate of inflation to 2.2 percent, keeping it above the average of 1.9 percent over the last five years. “With the Fed’s December rate hike largely priced in, it is unlikely that any modest fluctuations in the November CPI data would change the near-term course of gradual monetary policy normalization,” according to the Bloomberg Economics team.

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Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.

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