Markets out of whack? Investors say we're only getting back to normal

Marketwatch logo

Easy monetary policy has affected what investors view as 'normal' trading conditions, say analysts

Investors have been taken aback as months of calm were upended by a surge in volatility and market turmoil, with theS&P 500 and Dow Jones Industrial Average tumbling to their first correction in two years this week and the 10-yearTreasury note yield approaching a four-year high.

But as Wall Street acclimatizes to the resurgence of volatility, some say investors are simply receiving shocktreatment from a return back to "normal" after years of easy monetary policy and sloshing liquidity changed how assetsmoved, and distorted the way investors went about filling their portfolios.

"I was talking to somebody today who said, 'why are the markets acting so abnormal?' My response for the first time ina long time was that the markets are acting a bit normal," said Douglas Keebles, chief investment officer for AB FixedIncome.

Analysts, including Peter Boockvar of the Bleakley Advisory Group and Torsten Slok of Deutsche Bank, have repeatedlyargued the end of ultraloose monetary policy would pull the carpet out from under complacent investors who had grownaccustomed to low interest rates and placid trading conditions.

The Federal Reserve is projected to hike rates three times this year, at the same time it continues to unwind itsbalance sheet at a monthly pace that will accelerate to $50 billion by the end of 2018. Publicly announced wageincreases and a strong reading in the average hourly earnings segment in the jobs report have pushed up inflationexpectations, as measured through Treasury-inflation protected securities, to a three-year high.

"The Fed is simply trying to normalize, but a natural byproduct of their actions is that asset allocations are nowbeing normalized," said Arnim Holzer, global macro strategist for EAB Investment Group.

Investors also expect the European Central Bank and the Bank of Japan to signal a regime shift away from an era ofloose monetary policy if global growth spurs inflationary pressures.

The Dow Jones Industrial Average hand S&P 500 fell more than 10% from all-time highs set in late January, puttingthem in correction mode in Thursday. The Cboe Volatility Index , which measures expected volatility on the S&P 500 overthe coming 30 days, earlier this week spiked to levels last seen in early 2016. The VIX remains elevated, trading at34.78 on Friday, well above its long-term average around 19.

See: Why you shouldn't panic about the stock market volatility (

Yet market participants said it wasn't the resurgence of volatility as much as its preceding absence that wasstriking. The VIX plumbed single digits in 2017 and topped out above 17.

"Last year was really an aberration and not a normal year. We got accustomed to it, no doubt, but then La La Land isgenerally a comfortable place," said Mark Grant, chief global strategist for B. Riley FBR Inc., in a note.

But the brunt of complaints over easy monetary policy have mostly come from fixed-income investors, who havecomplained that negative to low interest rates brought about by the use of quantitative easing have crowded out privateinvestors, pushing them to the riskiest corners of the bond market in pursuit of incrementally higher returns.

In the backdrop of QE, yield-hungry investors snapped up dicey debt in emerging markets as far as Turkmenistan, whilemoney managers have shown a renewed thirst for bundled securities like collateralized debt obligations, which tend tooffer higher yields than their plain vanilla constituents but served as ground zero for the 2008 global financialcrisis.

Higher yields in government paper could hurt bond portfolios geared toward thriving in a low-rate environment. Inaddition, money managers priced out of government paper may be enticed back into Treasurys.

"We're moving through a type of sound barrier. On the way down, there was some instability as investors had toreposition their portfolios in the zero interest rate world. What's occurring now through the leadership of the Fed ishigher rates will meaningfully disrupt asset allocations," said Holzer.

Even the dollar has felt the wind of change. Since last year, the dollar has weakened even as interest rates havesteadily climbed throwing doubt on the conventional wisdom a stronger greenback would follow climbing interest rates asforeign investors pour money into U.S. markets to buy higher-yielding investments.

But this week saw a return back to the well-established relationship of a positive correlation between the dollar andbond yields ( The ICE dollar index rose 1.3% this week as bond prices tumbled, with the 10-year note yield reboundingmore than 20 points from its recent low of 2.65% on Monday. Bond prices move in the opposite direction of yields.

"Financial asset prices generally do better when the dollar is weaker. The interplay between all of them is startingto come back into play," said Keebles.

-Sunny Oh; 415-439-6400;