QE 'Tapering' Debate Points to Higher Volatility 

Kristina Hooper 

The Upshot 


Fears of the Fed unwinding its aggressive monetary policy sent volatility higher last week, a condition that could become more pronounced as investors connect the dots between positive economic news and the intensity of QE measures.

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Kristina Hooper, CFP®, CAIA, CIMA®, ChFC® is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

Ironically, good news on the economy may end up being a rally killer, or at least a driver of higher volatility. Sure, the Fed’s aggressive monetary policy has propelled the stock market to record highs in 2013. But as soon as investors get a whiff that the recovery is picking up pace, fears of an unwinding of quantitative easing seem to be kicking in. At least that’s what the VIX is telling us.

Last week, we caught a glimpse of those QE “tapering” jitters. The week started on a positive note for US stocks, with better-than-expected consumer confidence and a significant increase in home prices. However, it ended down, capped off by a late-Friday sell-off. There was a rotation within equities from defensive, high-dividend-yielding stocks to more cyclical, lower-yielding stocks. The 10-year Treasury yield backed up further.

Fear and Loathing

Perhaps the biggest news was that the VIX closed at 16.3, marking only the fourth time the VIX closed above 16 in 2013. The first time, on Feb. 25, was the result of inconclusive elections in Italy, which injected more uncertainty and anti-austerity sentiment into the euro zone. It happened again on April 15 and April 18, on the heels of the bailout crisis in Cyprus. Both events threatened the stability of an already fragile euro zone, which, in turn, had repercussions for global market stability.

Jumpin Jitters

So what triggered the VIX’s rise above 16 this time? It’s hard to pinpoint. But it seems to be a result of continued uncertainty about the possible tapering of quantitative easing. In particular, it appears to be a negative reaction to economic data that is perceived to be too positive and therefore a trigger for QE tapering. A case in point was last Tuesday’s news: We saw consumer confidence hit a five-year high. The reading, 76.2, was higher than expected and significantly higher than April’s reading. We also saw home prices rise 10.9%, as represented by the Case-Shiller 20-City Composite Index, locking in the highest year-over-year growth since April 2006. In fact, all three Case-Shiller indexes posted double-digit increases for the one-year period.

Favorable economic news may have been too much for investors, who initially welcomed the data, and then appeared to think better of it. It took reassuring words from Eric Rosengren, president of the Federal Reserve Bank of Boston, to quell the anxiety. Rosengren implied that it would be months before the Fed curtailed asset purchases, explaining it would be "premature" to stop quantitative easing with unemployment well above full employment and with core inflation still very low.

We saw a similar scenario on Friday, when Chicago PMI came in well above expectations; it was actually the best reading in more than a year. While investors initially celebrated the news, they soon changed their minds and sold off, perhaps fearing this could trigger a dialing down of quantitative easing. And investors are not only selling off stocks but also bonds. While an unwinding of QE is unlikely to occur in the near term, it could have significant ramifications when it finally happens. Last week’s rise in mortgage rates may have been a harbinger of things to come, as the 30-year fixed mortgage rate rose to its highest level in more than a year. A substantial uptick in mortgage rates could put a damper on the housing recovery as well as the refinancing activity that has padded consumer wallets and, arguably, has boosted sentiment.

Exit Strategy

In fact, last week the Organization for Economic Co-operation and Development (OECD) cautioned that central-bank exiting from monetary-easing programs will likely cause spikes in government-bond yields, which could pose a significant risk to the global economy. In the OECD’s most recent economic outlook, Chief Economist Pier Carlo Padoan warned: "Exit from unconventional monetary policy, when needed, may be difficult to manage and less smooth than desirable, possibly leading to sharp rises in bond yields and serious negative consequences for growth in a number of advanced and emerging economies."

It’s clear that the Fed has to manage the bond market through some extremely turbulent times in the coming years. One could argue that volatility may be more likely to rise in the foreseeable future now that investors recognize that quantitative easing is a dial that the Fed can turn up and down depending on the most recent economic data. Indeed, investors seem fearful that positive economic news effectively puts us one step closer to an end to QE.

On a longer term basis, the yield curve—a key gauge of equity volatility—has been signaling a ramp-up in volatility. Recall that the yield curve flattened through mid-2012, which is considered a forecast of weaker growth momentum and earnings pressure. Still, our general consensus is that the market is too premature in pricing in tapering; we think the “tapering watch” is more likely a 2014/2015 debate, rather than something we should worry about this year. However, that doesn’t mean investors won’t worry now, so we should all be prepared for more volatility in the near term as the great tapering debate continues.

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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.

A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
The Standard & Poor's 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the U.S. stock market.

Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index.

Purchasing Managers' Indexes (PMI) are economic indicators derived from monthly surveys of private sector companies. The Chicago-PMI survey registers manufacturing and non-manufacturing activity in the Chicago region. Investors care about this indicator because the Chicago region somewhat mirrors the nation in its distribution of manufacturing and non-manufacturing activity.

The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility.

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