Stocks, bonds and currencies have had a bumpy ride in the past few weeks, with Tuesday proving particularly volatile. The S&P 500 has dropped some 3.8% from its recent record high, while the MSCI Emerging Markets index is 8.2% off its early-September peak. Long-term U.S. Treasury yields rose sharply in the first half of September before falling just as sharply. European markets have swung similarly.
This could be because of recent poor economic data, such as Germany’s shocking 4% decline in industrial production in August, or gloomy predictions such as that of the International Monetary Fund, which Tuesday downgraded its global growth forecast again. Geopolitical risk has risen. But U.S. growth prospects appear bright, and it is hardly news that Europe’s economy is in poor shape.
Instead, markets may simply be suffering withdrawal symptoms. Until now, quantitative easing acted as a comfort blanket for investors, dulling the impact of bad economic news as investors anticipated further monetary accommodation. Even as the Fed has slowed its pace of bond purchases this year, its balance sheet has expanded by $427 billion, or 2.5% of U.S. gross domestic product.
Now investors face a period in which not only will bond purchases be absent, but the debate will be firmly about when U.S. rates rise. Instead of bad economic news being perceived as good for markets, good news may be seen as bad, in that it brings closer a Fed increase. The start of a new rate cycle is always a source of volatility; this one will be no exception. In fact, it may well be exacerbated by concerns that asset prices have been overinflated by central banks and that global growth is weak.
Some might put their faith in the idea that the European Central Bank will take up the baton and engage in sovereign-bond purchases. But for the ECB, such purchases seem an absolute last resort—and may be especially tricky as eurozone governments such as France flout the currency bloc’s budget rules. And even if the ECB were to buy eurozone government bonds, it would be unlikely to have the same global impact. Moves in the dollar and Treasury yields are felt around the world; the same isn’t true of the euro and Bund yields.
For policy makers, clarity of communication will be key during this period; the Fed will be moving from being a source of reassurance to a source of uncertainty. But they should resist any temptation to quell financial-market volatility caused by the turn in the U.S. rate cycle unless there is a real risk of damage being done to the economy.
Global markets need to learn to stand alone again, without the support of Fed bond purchases. That process is likely to be painful. But it is also essential.