The recent market correction signals a return to greater volatility, writes Oliver Mangan
Stocks staged a good recovery over the course of last week, with most markets up by around 3% to 5% from their lows of the previous week.
However, markets are still 5% to 10% below their January peaks. This supports our view that the recent correction is unlikely to be a precursor to a major stock market crash but rather signals a return to greater volatility.
Other trends also re-established themselves, namely downward pressure on the dollar and upward pressure on bond yields. The recent instability in financial markets has its roots in a hardening of interest rate expectations as central banks start to row back on super-easy monetary conditions.
At this stage, markets have moved to discount rate increases that would take official rates up to around 0.5% in the eurozone, 1.5% in the UK, and 2.5% in the US by the end of 2020.
A key question is whether markets have priced in enough rate tightening in the next couple of years.
The answer in most cases is probably yes, provided inflation remains relatively subdued.
Thus, not surprisingly, inflation indicators are moving right to the top of investors’ agendas as something to be watched very closely.
The one market which may see a further hardening of rate hike expectations is the US.
The US Federal Reserve has projected US rates are likely to increase to 3.1% by 2020, but the market is pricing in that they will rise to just 2.5%.
This disagreement, then, lies in regard to the extent of interest rate rises in 2019 and 2020. The latest developments suggest that the Fed’s higher rate projections may be closest to the mark.
Not only are significant tax cuts being implemented in the US, but the President Donald Trump’s administration is also looking for sizeable increases in current and capital spending.
This could well see the re-emergence of worries about the so-called twin US deficits: The budget and balance of payments deficits, as well as concerns about an increased risk of overheating in the US economy.
For Europe, though, the likelihood is that rates will remain very low in the next couple of years. Unlike in the US, only one rate hike is expected in the UK this year, with ECB rates remaining unchanged. Only modest rate increases by the Bank of England and ECB are anticipated thereafter.
Oliver Mangan is chief economist at AIB
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