HOW TO READ THE DOW JONES UPS AND DOWNS / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

November 3, 2014 5:57 am

How to read the Dow Jones ups and downs

Mohamed El-Erian

Three possible explanations have differing market implications

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©EPA

 

The Dow Jones index has moved more than 100 points up or down on many trading days over the past four weeks, marking an impressive return of stock market volatility . Yet the broader implications are far from clear, if only on account of the different possible causes.

 

Markets care about two-way volatility because it influences portfolio construction. The lower the volatility, the smaller the probability of traders being stopped out of positions by rapid price fluctuations, and the greater the enticement to pile on risk.

It is therefore not surprising that four years of repressed volatility have encouraged risk-taking beyond what is warranted by the underlying fundamentals. Indeed, an objective of unconventional monetary policy is to suppress volatility in order to bolster asset prices and trigger positive economic responses on the part of (now wealthier) households and (now more motivated) companies. In other words, to promote higher financial risk-taking not as an end in itself but as a means to bolster greater economic risk-taking.

 

In this context, the recent fluctuations in the Dow Jones index are particularly noteworthy, as they come after a period of unusual market calm in the midst of geopolitical tensions and economic surprises.

There are three possible explanations, with differing economic and market implications. First, the volatility is the result of one-off disturbances elsewhere, the impact of which is both temporary and reversible. Second, it signals an upcoming policy transition in which some central banks no longer seek to repress volatility to the same extent, while others do. Third, it reflects central banks’ growing collective inability to achieve that effect.

 

 

In the first scenario, it is only a matter of time until central banks are again able to contain volatility. In that case, recent fluctuations in the Dow Jones can be seen as noise rather than signals. They would not point to any significant economic or policy inflection points, with the world remaining in a low-level growth/policy equilibrium. Moreover, with little spillover to interest rate volatility, there would be no immediate worries about the outlook for government bonds or risk assets such as equities .

In the second case, recent volatility signals a higher likelihood of orderly policy changes induced by economic development. With the US economy continuing to heal, the Federal Reserve would look to normalise its policy approach, reducing even faster what has been a prolonged reliance on unconventional instruments – particularly in light of growing concerns about the implications for inequality, excessive risk taking, market functioning and, therefore, financial stability down the road.

In this scenario, the Fed’s confirmation last week that it is ending its programme of large-scale asset purchases would be followed by gradual interest rate rises. The initial volatility signalling this policy transition would give way to renewed stability in the context of a firmer foundation for risk assets: that of an economic recovery underpinned by stronger fundamentals rather than unconventional policies. Meanwhile, interest rate volatility would also edge higher, making bonds less attractive, but marginally so as interest rates would rise in a muted manner.

The moderation of equity volatility in these two explanations means there would be no need for markets to downwardly adjust their expectations of future returns on risk assets, especially if other central banks are doing more (as was the case last week with the Bank of Japan and soon with the European Central Bank). Not so under the third explanation, which speaks to declining policy effectiveness. Here, central banks are less able to counter the cumulative impact of economic, geopolitical and social forces. This means equity volatility would revert to higher long-term historical averages.

 

For now, consensus has embraced the first explanation, both outright and as the ongoing transition to the second state of the world. This has led to an impressively quick and strong recovery from the losses experienced in the first half of October. Yet investors are far from relaxed about the volatility spike, and understandably so. The recovery is less to do with convincing facts on the ground and more with repeated market conditioning during a prolonged period of experimental central bank policy.


Mohamed El-Erian is chief economic adviser to Allianz and author of “When Markets Collide”