My opinion is that 2015 will be known as the year of volatile spirits. Markets of all types will be impacted by the nascent recovery in the US, the market’s take on the Fed’s take of when interest rates there should be raised, as well as the cross-currents of Eurozone QE and commodities prices.
Added to all of that will be unexpected shots in the international currency wars; we’ve already seen numerous howitzer shells unexpectedly lobbed over the line by a number of the world’s central banks.
And that’s just in January!
So if you needed any more proof that markets are in for a ride, here it is:
In short, when the $US Index rises by more than 8% from its 3-year average, 12 months’ later equity market volatility increases significantly. This proved to be the case since the 1970s, applying to the Latin American debt crisis, the Asian crisis and the dotcom boom.
The exceptions were Black Monday 1987, and the GFC, where, with the meltdown starting in the US, the equity market downturn occurred coincidentally with the currency appreciation.
One year after a currency appreciation can be difficult for markets. As a result of the relative price changes, there is likely to be an increase in domestic spending on imports, and reduced demand for exports in foreign countries.
So US earnings from exports can slow in that period, hitting equities, while one year is too short a period to see positive currency effects for the rest of the world.
Another reason for the timings described in the chart above is the greenback’s position as the global reserve currency. As the Fed start to tighten monetary policy, interest rate differentials push the US$ higher. Rising US interest rates promote capital flows into the US, forcing the tightening monetary conditions to other economies.
The one year lag is consistent with the lag of monetary policy transmission to the real economy. As the tightening effects unfold, the economies who borrow in US$ are further affected and volatility ensues.
I’m unsure if the mechanisms will be the same this time around but the US dollar strength is yet to be fully transmitted into other markets.