Tuesday June 27

Stocks fell today following hawkish comments from Mario Draghi as well as further political deadlock in Washington. The S&P 500 fell 0.8% to 2,419 and the Dow Jones fell 0.5% to 21,310. The KBW Bank index rose 0.8% and utilities lost 1.4% as rates went higher. John Williams of the San Francisco Fed spoke and mentioned low growth in developed economies around the world. Patrick Harker spoke and came across as hawkish saying that the Fed should have its balance sheet normalization policy on “autopilot” and coming across as hawkish on rates in spite of low inflation. Investors today also focused on comments made by Mario Draghi that were bullish on the European economic recovery and investors took that as a sign that tapering may be forthcoming. Some analysts are expecting an announcement of tapering as soon as September. Also driving downward sentiment today was news out of Washington that a vote on healthcare would be delayed until after July 4. On that backdrop the 2 year Treasury yield rose 4bp to 1.37%. The 10 year Treasury yield rose 7bp to 2.21%. Accordingly 2yr vs 10yr bear steepened to 0.83%. USD was weaker for the most part on the day. USD fell 1.5% against EUR to $1.1343. USD rose 0.4% against JPY to Y112.34. USD fell 0.8% against GBP to $1.2823. The weaker dollar supported oil prices for the second consecutive day. WTI rose 1% to $43.82. Brent also rose 1% to $46.27.

Across markets investors are wanting to hedge their exposure given uncertainty and the lingering feeling that markets may be due for a turnaround. Movements in equity, fixed income, and currency markets all reflect some investor concern. In equities while the VIX has drifted lower, the ratio of the VVIX to the VIX has increased to an all time high which suggests anticipation for a spike in volatility in the near future. Additionally the put-call ratio spiked up in June close to the highest level of 2017 which is indicative of investor bearishness. Additionally utilities have rallied this year which is normally a defensive sector. In the rates market the Treasury yield curve between 2s and 10s has flattened and is approaching the lowest level since 2007. That could suggest markets pricing in a monetary policy mistake, such as the Fed raising rates too much too soon which subsequently dampens inflation and hurts the economy. In FX markets haven currencies such as the Japanese yen and the Swiss franc have both rallied this year.

Much of the low volatility in financial markets can be attributed to low volatility in underlying economic conditions. The three year rolling standard deviation of the annualized quarterly change in GDP has reached its lowest level ever at just 1.5% in the United States. Part of that reason is that GDP has been low, and a smaller number tends to move around less on absolute terms. Other economic data points however have been less volatile as well. Some have attributed part of this shift to better technology, as for certain economic data figures better technology allows companies to better assess their inventory or capital goods needs and not overstock themselves. Globally this has been the trend of low economic volatility. It is resulting in low financial volatility as in the second quarter the average daily move in the S&P 500 has been 0.3% which is the lowest in more than 50 years. Another part of the reason for low volatility has been central bank activity which has been a safety net for economies around the world. The risk is that investors like low volatility in the economy and to some extent in markets, they could be get too complacent with calm conditions and be caught off guard once things change.

Mario Draghi’s speech today seemed to catch investors off guard based on the response in currency and government bond markets. Draghi came across as hawkish, speaking bullishly about the European economic recovery which has shown growth for 16 consecutive quarters. Inflation is picking up and is currently around 1.3%. Draghi said that if the ECB continues its current track of monetary policy coupled with the strengthening economy, that would effectively be an increase in stimulus. Coupled with comments made earlier this month at a policy meeting about not lowering interest rates any further, it seems as if the ECB is setting the groundwork to take a hawkish stance at the start of 2018. The ECB’s QE program in which it buys EUR 60bn a month is set to expire in December. Analysts after today expect that to be reduced to EUR 40bn in January of 2018 followed by another reduction to EUR 20bn in the second half of next year. That is a relatively slow pace of tightening. Another factor that may be encouraging the ECB to reduce accommodation is a decrease in political risk. As the political uncertainty fades companies may be more likely to expand and make investments which is stimulative for the economy. That would be a major shift in global financial markets, and it would put two of the world’s largest central banks in a tightening bias together for the first time in this recovery since the financial crisis.

Tuesday June 27

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