Whiskey Au Go Go - the year of volatile spirits
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:
Source: Bloomberg
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.
Frequently Asked Questions about this Article…
2015 is dubbed the year of volatile spirits due to the combination of a nascent US recovery, the Federal Reserve's interest rate decisions, Eurozone quantitative easing, fluctuating commodity prices, and unexpected moves in international currency wars. These factors contribute to increased market volatility.
When the US Dollar Index rises by more than 8% from its 3-year average, it historically leads to significant increases in equity market volatility 12 months later. This pattern has been observed during past financial crises, such as the Latin American debt crisis and the dotcom boom.
A strong US dollar can lead to increased domestic spending on imports and reduced demand for US exports in foreign countries. This can slow US earnings from exports, negatively impacting equities, as the positive effects of currency appreciation take longer to materialize globally.
The one-year lag is due to the time it takes for monetary policy changes, like interest rate hikes, to transmit to the real economy. As the US dollar strengthens, economies borrowing in US dollars face tighter monetary conditions, leading to increased volatility.
As the global reserve currency, the US dollar's strength influences capital flows and monetary conditions worldwide. When the Federal Reserve tightens monetary policy, it raises US interest rates, attracting capital to the US and tightening conditions in other economies, contributing to market volatility.
Interest rate differentials, driven by the Federal Reserve's policy decisions, can push the US dollar higher. This attracts capital flows into the US, impacting global markets by tightening monetary conditions in economies that borrow in US dollars, leading to increased volatility.
Historical events like the Latin American debt crisis, the Asian crisis, and the dotcom boom have demonstrated how US dollar appreciation can lead to increased market volatility. However, exceptions like Black Monday 1987 and the Global Financial Crisis showed coincidental downturns with currency appreciation.
While the mechanisms may differ this time, the current US dollar strength is expected to impact global markets. The full transmission of its effects is yet to be seen, but historical patterns suggest potential for increased volatility as economies adjust to tighter monetary conditions.
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