Financial Markets Monitor

Is today’s low volatility a sign of calm or a threat to financial stability — or both? This edition investigates the volatility paradox: the possibility that low volatility leads investors to behave in ways that make the financial system more fragile and prone to crisis.

The bull market in U.S. stocks extended into its eighth year as major U.S. equity indexes rose during the first quarter, supported by an upswing in confidence, solid corporate earnings, and the expectation of faster U.S. economic growth. Equity market volatility and corporate bond spreads fell to near cyclical lows but stock valuations remained elevated.

U.S. long-term interest rates have risen from all-time lows in July, driven by stronger global economic data, higher inflation expectations, and growing expectations of a U.S. shift from monetary to fiscal policy stimulus. However, U.S. long-term rates and volatility remain low by historical standards.

Investors’ risk appetites quickly recovered in the third quarter from the initial shock of the United Kingdom’s vote to exit the European Union. The ultimate financial and political effects of the U.K.’s exit will take months or years to negotiate, and could introduce further confidence shocks to global markets.

The United Kingdom's vote to leave the European Union was the defining focus of financial markets in the second quarter. Although the immediate market volatility has subsided, the policy uncertainty and the ultimate financial and political spillovers may last for months or years, leaving markets vulnerable to further confidence shocks.

Global risk assets sold off sharply in the first six weeks of 2016. They have partly recovered, but the underlying themes of weak global growth outlooks, low oil prices, and uncertainty about policy options remain. This edition of the markets monitor discusses negative interest rates, the sell-off in bank stocks, and the high levels of U.S. stock valuations.

Prices of equities and other risky assets have declined markedly in 2016 due to concerns about global growth and low oil prices. Developments in China fueled market concerns about the effectiveness of Chinese economic policies, while oil oversupply pushed prices to lowest levels in more than 10 years. NOTE: After this issue, the Financial Markets Monitor will change to a quarterly schedule.

Divergence of monetary policies in major economies continued to be a dominant theme in markets. The European Central Bank announced at its December meeting new easing measures, while the Federal Reserve is broadly expected to lift interest rates at its December monetary policy meeting.

Risk assets appreciated notably in October, recovering somewhat from the sharp losses in recent months. The dominant driver appeared to be a delay in market expectations for the Federal Reserve to raise interest rates.

U.S. financial markets have been more stable in September, following a marked deterioration in August. However, investor risk appetite appears to be weaker than before the sell-offs and underlying concerns persist about emerging market growth.

Risk aversion intensified in August following China’s surprise renminbi devaluation and its shift toward a more market-oriented currency regime. The currency moves magnified market concerns about slowing global growth and inflation, causing pronounced sell-offs in markets for commodities, emerging market currencies, and global equities.

Important developments in Greece, a sharp equity market correction in China, and Puerto Rico’s announcement of a potential debt restructuring have driven risk sentiment in financial markets. A key market focus has been the increased uncertainty in Greece since late June. Developments there remain fluid; a more disorderly outcome may test the stability of broader euro area markets.

Over the last month, long-term euro area bonds experienced a sharp sell-off, leading to outsized moves in other major global bonds, including U.S. Treasuries. The sell-off reflects a partial unwinding of the euro area “QE trade,” in which investors established sizable positions in euro area bonds, equities, and the euro in response to the European Central Bank’s expanded asset-purchase program.

Yields on long-term bonds in advanced economies are at historically low levels. Several factors appear to be at work. While financial stability risks currently appear moderate, a persistence of low long-term Treasury yields could lead to a buildup of such risks if it encourages excessive borrowing or investor risk-taking.

The divergence of global monetary policies remains a dominant theme, driving important market trends. While the Federal Reserve is expected to tighten policy, many other central banks are undertaking additional easing. The expansion of quantitative easing programs and negative interest rates — which may be justified to prevent economic stagnation — entail financial stability risks that warrant monitoring and, where possible, mitigation.

Financial market volatility has increased significantly since late 2014. This is a shift from several years of largely depressed volatility, which contributed to excessive financial risk-taking as discussed in the OFR 2014 Annual Report. It remains to be seen whether this is an enduring normalization of volatility and what lasting effect, if any, it will have on financial risk-taking and stability.