By Christopher Neely, Assistant Vice President and Economist
Financial markets have become unusually volatile in recent weeks. The charts below show that the widely watched VIX index of stock market volatility is now very high. In fact, it is higher than it has been since 2012. At the same time, 10-year Treasury yields, equity prices and oil prices have all declined substantially, while the value of the dollar has risen.
These recent asset price trends are consistent with recent news that lowered expectations of U.S. growth.1 For example, the Organization of Economic Cooperation and Development reduced its growth forecasts for the U.S. and other major economies on Sept. 15, and the Commerce Department announced on Oct. 15 that U.S. September retail sales fell by a more-than-expected 0.3 percent.2 In addition, concerns about the Ebola virus and the international security situation have made investors edgy.
One movement that might appear to be paradoxical is the sharp increase in the foreign exchange value of the dollar over the past few weeks. The foreign exchange value of a currency is often linked to expectations of that country's growth relative to its trading partners. It would be unusual for declining U.S. growth to be linked to a rising value of the dollar. In the present case, however, expectations of European and Japanese growth may have declined more than those of U.S. growth. For example, on Oct. 14, Germany’s Economy Ministry reduced its 2014 forecast from 1.8 to 1.2 percent and its 2015 estimate from 2.0 to 1.3 percent.3 An alternative explanation is that the rise in the value of the dollar could reflect the demand for safe assets during a period of high uncertainty.
The decline in long-term U.S. interest rates during a period in which the Fed's asset purchase programs have been slowed might also appear counterintuitive. In fact, because financial markets are forward-looking, they have long since priced in expectations of the slowing and eventual end of the asset purchase programs. Therefore, one should expect little or no changes in yields when the programs are actually ended.
The decline in oil prices—though welcome to consumers of oil—will tend to temporarily reduce inflation in oil-consuming nations and may delay the long-anticipated removal of unusual monetary accommodation by their central banks. That is, central banks that are concerned about missing their inflation targets on the low side may worry about unwelcome disinflation.
It remains to be seen whether subsequent changes in fundamentals, such as growth rates, will justify these asset price movements. One strand of financial research suggests that asset prices are excessively volatile compared to the fundamentals on which they depend.4
1 Unexpected increases in U.S. shale oil production could have contributed to the decline in oil prices.
2 Hannon, Paul. “OECD Cuts Economic Growth Forecasts,” The Wall Street Journal, Sept. 15, 2014. “Moderate Global Growth Is Set to Continue, but Weak Demand in the Euro Area Remains a Concern,” OECD Interim Economic Assessment, Sept. 15, 2014. “Retail Sales Give Cautionary Sign on Demand,” Reuters, Oct. 15, 2014.
3 “Germany Cuts Growth Forecasts to 1.2% This Year, 1.3% Next,” Reuters, Oct. 14, 2014.
4Shiller, Robert J. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?" The American Economic Review, June 1981.