Policy Divergences Driving Market Volatility

By Brian Dolan, Head Market Strategist

 Looming Shakeout May Offer Investing Opportunities

The key theme driving global markets is the central bank policy split between the US Federal Reserve (the Fed) and the rest of the world’s major central banks. The Fed is increasingly expected to raise interest rates as early as June, while other major central banks continue to pursue ultra-easy monetary policies to stimulate their economies and fend off deflation.

The effect is most readily seen in stock market returns where US indexes are mostly flat for the year in contrast to 15-20% gains in Europe and around 7% in Japan, all in local currency. The other glaring development has been a soaring US dollar (USD) and a slumping Euro (EUR) and soft Japanese yen (JPY). These are the hallmarks of an interest rate driven market environment and where investors should focus their attention in the coming weeks and months.

Easy Money Europe

This week marked the start of the ECB’s asset purchase program, where it is expected to buy EUR 60 billion per month of Euro-area government debt. The asset purchase program is expected to total EUR 1.1 trillion and last into Sept. 2016. The ECB was forced into this quantitative easing (QE) to fight sluggish growth and deflationary pressures. The immediate effect has been to see Euro-area government bond yields fall further, with many shorter-term maturities (5 years and less) registering negative yields. (At maturity, an investor who bought negative-yielding debt receives less than they originally paid.)

The ongoing ECB program is most likely to continue to keep pressure on Euro-area interest rates and the EUR, while potentially continuing to support Eurozone stock markets. The major risk is that the European economy fails to respond to the additional monetary stimulus and instead continues to languish. Monetary policy acts with a lag of about 6-9 months, so the rest of 2015 could be problematic. There is also a further risk that Greece will fail to satisfy its EU creditors, triggering a banking crisis in Greece in the weeks ahead and potentially triggering negative market volatility.

Fed Poised to Hike

In the US, market expectations for the Fed’s first rate hike in six years has been moved up in light of the strong Feb. employment report. US 10-year Treasury yields have risen by over ½% since unexpectedly robust jobs data were reported for Jan. and Feb. The Fed next meets on Mar. 18, and while no change in rates is expected at that meeting, markets will focus on the language of the Fed’s policy statement.  The key will be whether the word ‘patient’ is dropped from the Fed’s forward guidance. If so, markets will take it as a signal the Fed is likely to first hike at its June 17 meeting.

US stocks appear to have already formed a medium-term (multi-week) price top in anticipation of such a Fed signal. Further near-term weakness seems likely if the Fed signals a June move, but we would remain opportunistic buyers on pullbacks, as the longer-term picture still favors the US recovery. The S&P 500 Index, having dropped below the 50-day moving average (m.a.) and sitting on the 100-day m.a. at 2042 (SPY 204.2), has important long-term support around the 2000 level (SPY 198/202) , where the 200-day m.a. and the 50-week m.a. converge. Key trend line support dating back to Oct. 2011 comes in lower around 1924 (SPY 1918).

My own preference is for the Fed to continue to bide its time and maintain the ‘patient’ language. The risks of raising too soon far outweigh any potential benefits. And while the USD remains strong, inflation is unlikely to materialize anytime soon. Should the Fed retain ‘patient,’ US and global equities are likely to rebound quickly, as markets re-adjust to a lower-for-longer Fed policy stance.