Asset Management

Volatility rises on Fed policy worries, global concerns

William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets

February 22, 2013

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Global equity markets hit some turbulence during the past week. Optimism turned to pessimism amid rumors of hedge fund liquidations, a perceived tightening of Chinese monetary policy, and signs that Europe’s economic downturn worsened in February. The crowning blow was the release of minutes from the January meeting of the Federal Reserve’s Federal Open Market Committee (FOMC), which fanned fears that “open-ended” quantitative easing may not be as open-ended as the market had hoped. The S&P 500 Index and the MSCI All Country World Index (ex-U.S.) were down by roughly 1% for the week through February 21 but began trimming those losses the following day.

Article Highlights

  • Equity markets are rattled by fear of a sooner-than-expected end to quantitative easing.
  • Treasury yields inch lower, while “spread sectors” are mixed in a volatile week.
  • U.S. economic data treads water as longer-term growth trend remains intact.
  • Europe stays in recessionary territory, but Germany’s outlook is a bright spot.
  • China’s monetary moves and Italy’s pending election have markets on edge.

In fixed-income markets, yields on most “spread” products (higher-yielding, non-U.S. Treasury securities) widened slightly relative to Treasuries during the week, in sympathy with the increase in equity market volatility. Among investment-grade corporate bonds, financial issuers continued to outperform industrial names, in part because financial companies are not at risk of being targeted for leveraged buyouts (LBOs). Although weekly flows into high-yield bond funds have been negative in recent weeks, fund flows have been positive for high-yield loans, which offer some protection against rising interest rates because they are floating-rate instruments. Treasury yields inched lower during the week, with the 10-year security closing at 1.99% on February 21, after spending most of the month to date above the 2% threshold.

Fed meeting minutes dominate U.S. economic releases

The FOMC’s meeting minutes underscored the Fed’s internal debate about the cost of the quantitative easing (QE) program, the strength of the U.S. economy, and how long the program should last. Although the minutes were consistent with other recent communications indicating that the Fed would soon start to assess the potential phasing out of QE, financial markets were unnerved by the possibility that it might happen sooner than anticipated.

Other U.S. releases during the week were mixed:

  • Housing starts declined from an upwardly revised December total, but building permits rose in line with the recent trend suggesting further growth in the months ahead.
  • Existing home sales moved sideways last month, in large part because the inventory of homes for sale hit their lowest level since 1998.
  • Inflation data was benign, as expected, with the consumer price index flat in January and up a modest 1.6% year-over-year. A more important and broader measure of inflation, the Personal Consumption Expenditure (PCE) Deflator, remains at about 1.4%.
  • First-time unemployment claims ticked up for the most recent week and for the four-week moving average period, but claims stayed in the lower range of a band that has held for much of the past year. The broader trend remains down.
  • The index of leading economic indicators published by The Conference Board rose 0.2% in January — a bit below expectations but a sign that the economy will continue to expand in the near term.

In addition, the “flash” (preliminary) Purchasing Managers’ Index (PMI) for the U.S., published by Markit, showed that manufacturing activity is still expanding, but at a slower rate. Meanwhile, the Federal Reserve Bank of Philadelphia’s Philly Fed index, a measure of regional manufacturing activity, declined in January, versus expectations of a slight increase.

Europe’s downturn deepens

There was further evidence of recessionary conditions in Europe:

  • The Markit composite PMI, covering both the manufacturing and service sectors of the eurozone economy, declined in February, hitting a two-month low.
  • Among individual eurozone countries, including Germany and France, manufacturing PMIs improved, but most service-sector PMIs weakened.
  • Inflation measures released during the past week were lower across the continent, reflecting weak demand.

On the positive side, the German ZEW Economic Sentiment Index, a broad gauge of investor views on the outlook for Germany’s economy, surged to a nearly three-year high in January.

Chinese monetary moves weigh on equities, commodities

China’s central bank executed massive repurchase agreements to drain reserves from the banking system during the past week. Although taking some liquidity out of the system is routine following the Chinese New Year, the size of the move (about $146 billion net) was far greater than expected. This move, coupled with rumored price controls on new homes and other constraints on real estate, sparked fears that China is beginning a new cycle of monetary tightening — fears that sent commodity prices tumbling, along with the Shanghai Stock Exchange “A Share” Index. While these developments warrant monitoring, we caution against finding a trend in one data point.

In Japan, the yen has remained exceptionally weak since the beginning of the year. This has put upward pressure on the U.S. dollar and has led many to wonder how far Prime Minister Shinzo Abe’s administration will go to weaken the currency. Whoever Abe nominates to take the helm at the Bank of Japan may provide a good signal on the yen’s future direction.


Our forecast for a gradually strengthening U.S. economy remains intact. We believe this view is supported by the Fed’s January meeting minutes, in which debate about the continued need for further monetary stimulus is driven in part by the relative strength of the recovery. At the same time, we see no substantive inflationary pressures and do not expect any to materialize until the pace of growth picks up further, leading to increased wage inflation.

While equity markets reacted negatively to the Fed minutes at mid-week, the S&P 500 Index found support at the key 1,500 level and rallied higher as the week was drawing to a close. That said, market volatility has increased, as the CBOE Volatility Index (the VIX, or so-called “fear index”) spiked on February 20 after hitting a multi-year low the day before. The VIX tracks the implied volatility of the S&P 500 Index. The slump in commodity prices, which triggered hedge fund liquidations and equity sales during the past week, remains a concern. Also weighing on equity markets, particularly in Europe, is the Italian national election slated for February 24-25. As of this writing, the markets’ feared worst-case outcome — an outright win by controversial former Prime Minister Silvio Berlusconi — still appears unlikely.

Fixed-income markets are also focused on Italy, as well as on the effects and duration of the U.S. budget sequester, should it take effect, and the impact of higher gasoline prices and payroll taxes on consumer sentiment. Until there is more clarity on these issues, Treasury yields are likely to remain in a tight range. In the second half of 2013, however, we expect Treasury yields to come under increased pressure as the economic tailwind provided by the housing market picks up and the Fed offers additional guidance on the eventual winding down of its quantitative easing program.