Although highly accommodative monetary policy settings are supportive of low volatility, the very benign readings appear to be at odds with recent geopolitical events including North Korea, the US debt ceiling, the possibility of US government shutdown and the shift to less-dovish rhetoric from many key central banks.
In recent times, the US Federal Reserve minutes have highlighted concern about rising financial stability risks. Specifically, some FOMC members are concerned financial markets aren’t adequately pricing risk and thus asset prices could be vulnerable to a correction.
It is notable US financial conditions have eased since December 2016. Since then the Fed has hiked by 25 basis points on three occasions and has signalled its intent to start gradually winding down the balance sheet in the fourth quarter of 2017.
The effect of quantitative easing unwinding on asset allocation decisions and thus pricing will become clearer over time.
Intuitively, as central banks bought bonds, yields fell, making other financial assets more attractive. As growth in central bank demand for bonds is set to slow and ultimately fall, other investors will have to buy those bonds.
This has implications, not just for the price of bonds but for other asset classes. As the market adjusts to the new equilibrium of a major buyer dropping out, the implication is that volatility could pick up.
Tom Kenny is a Senior Economist at ANZ