After many years of stability, global financial markets appear to have entered a new phase characterized by increased volatility. Since the recent market volatility that began with January's sell-off and has continued, attention has focused on volatility and CBOE Volatility index-related products, it is really symptomatic of larger and more complex changes in our financial markets that, in turn, reflect changes to our monetary and fiscal policies that implicate a growing role for international institutional investors to fund our economy in the years to come.
The underpinnings of this volatility began many months ago — well before the market gyrations of the past few weeks — when the dollar started to decline and U.S. interest rates began to rise. With many of the U.S. economic indicators trending upward, the central banks led by the Federal Reserve have begun to raise interest rates and to shed the assets purchased through quantitative easing.
Adding fuel to the fire, Congress and the administration appear to have little concern about the ballooning deficit. In the first week of February, the U.S. government, in an unprecedented move, announced a massive fiscal stimulus to the tune of $300 billion in debt to avoid a government shutdown at a time when the economy is growing strongly and Americans' savings rate is low and declining. And the final budget that Congress passed the following week calls for even more spending without any pretense to balance the budget.
The United States now projects a budget deficit in excess of $1 trillion in the coming year plus about $420 billion due to "sales" from the Federal Reserve portfolio of Treasuries and agency mortgages; and another projected $600 billion in sales the year after that. This creates the unusual scenario whereby the U.S. is reversing monetary stimulus while increasing fiscal stimulus — one foot on the brake and one foot on the accelerator! This is exactly the opposite course of action that would be expected by conventional economics.
The burning questions are: Who will fund this extraordinary increase in the deficit, and what effect will it have on the investment climate?
Certainly, domestic savings might be called upon. Some investors likely will be required to sell stocks and corporate bonds to buy Treasury securities. But this won't go nearly far enough. The likely answer is that international investors will have to step in to fund the U.S. deficit.
Part of the answer may lie in Congress' apparent disregard for deficit spending during an era of relative prosperity that was greeted by the Trump administration. The administration's complete silence on this topic reminds me of the Sherlock Holmes comment about "the dog that did not bark in the night." This "clue" — the failure to address the effects of these policies on the deficit — sends a clear signal to international investors either not to hold investments in the United States or to demand a very high price to do so.
We will have to wait and see if non-U.S. institutional investors will step up and fund a drastically large U.S. deficit.
What is much more certain, however, is that the result of all of these simultaneous and even contradictory trends will be substantially higher volatility in financial markets and potentially higher interest rates. Equities will struggle despite the strong economy and the rising rate environment will pressure bonds as well. These conditions will create a much broader opportunity set for fixed-income relative value strategies that can capitalize on a higher volatility investment environment vs. traditional fixed-income portfolios, which might struggle.
The global financial markets have indeed entered choppy waters. Volatility is here to stay for the foreseeable future. Buckle up!