Over the past four weeks, stocks have staged an impressive rebound from their February lows. But too much of a good thing can sometimes come with a downside. And so it is with this recent rally, which has pushed volatility back down, but perhaps too low.
That means the stage could be set for a return of volatility and another selloff.
A Mixed Reaction to the ECB
Stocks rallied again last week as investors digested an extensive expansion of the European Central Bank’s (ECB’s) stimulus program, which included an impressive array of old and new tools. The ECB cut its deposit rate by 10 basis points (0.10%) and lowered other policy rates by five basis points. The package also included an increase in the pace of quantitative easing — to the tune of an additional 20 billion euro per month. To accommodate the larger monthly bond buying, the ECB added corporate nonbank investment-grade debt to the list of assets it may purchase. Finally, the ECB expanded a number of lending programs aimed at spurring further credit growth in the euro area.
The initial reaction on Thursday was mixed. Stocks ended the session lower following comments from ECB President Mario Draghi suggesting that further rate cuts were unlikely, but did manage to stage a strong rally on Friday. That notwithstanding, one of the not unwelcome side effects of the ECB program would be a weaker euro to make European exports more competitive. Yet, despite the size and extent of the package, the euro remained higher against the dollar.
Last week’s equity gains were accompanied by some lessening in investors’ appetite for so-called “safe havens,” particularly U.S. Treasuries. Bonds sold off and rates continued to rise, with the yield on the 10-year Treasury pushing back to 2%. Short-term yields are also rising as investors recalibrate the odds of another Federal Reserve (Fed) rate hike later this year. Futures markets are now suggesting a greater than 70% chance the Fed will hike by year’s end. The yield on the two-year note is up roughly 35 basis points over the past month.
Relief Rally: Too Much Too Soon
The equity rebound of the past month is a classic “relief rally,” where investors are relieved conditions are not as bad as they previously feared. This one has been partly predicated on hopes that China is stabilizing, which helps explain the sharp rise in commodity prices given that China is the biggest commodities consumer.
Unfortunately, signs of real improvement in China are scant. While the U.S. appears to be stabilizing, the Chinese economy remains challenged. The latest evidence came in the form of a 25% plunge in Chinese exports. This was the largest single-month drop since 2009. The government is likely to try to stem the decline with some palliative measures, but a large stimulus package remains unlikely. Furthermore, the drop in Chinese exports calls into question not just the state of the Chinese economy, but the global trade picture as well.
Against this backdrop of continued uncertainty in the global economy, the recent rally is beginning to look a bit excessive. This is particularly evident in the sharp drop in volatility. The VIX Index, a key measure of equity market volatility, has fallen to about half of its February peak. Meanwhile, the VVIX [Index], which measures the volatility of volatility (or, more precisely, how frequently volatility spikes occur), is back to its lowest level since last August.
Given the still uneven pace of global growth and tighter financial market conditions, this may, too, be low. This, in turn, suggests the potential for a rise in volatility — which would imply another bout of stocks selling off. March may have come in like a lamb, but the lion may be lurking
Koesterich is global chief investment strategist with BlackRock, the largest asset manager in the world.