Review & Outlook, August 2017

Implied volatility in both the U.S. equity and Treasury markets sank to historic lows in July. The decline can mainly be attributed to constructive earnings reports, solid economic growth indicators, decelerating inflation measures and renewed dovish attitudes by leading central bankers. But extremely low volatility has proved fleeting in the past. Markets are poised to transition to a more volatile period through the rest of the year, with several economic policy developments serving as potential catalysts.

Implied Volatility Indices Sit at Historic Lows

Data source: Chicago Board of Options Exchange and Merrill Lynch, 1/1/90 to 8/4/17. Past performance is no guarantee of future results. Representative indices: Equity: CBOEs Volatility Index (VIX); U.S. Treasury: Merrill lynch Option Volatility Estimate Index (MOVE). Indexes are unmanaged and unavailable for investment.

Catalysts Are Poised to Boost Market Volatility

Fiscal 2018 Budget - A more pro-growth budget would support growth and be consistent with lower implied equity volatility. But such policy would also create more inflationary pressure, larger deficits and tighter Federal Reserve (Fed) policy. It suggests a higher level of U.S. Treasury yields and greater volatility than current readings indicate.

A stimulative budget is not a given, based on the budget plan passed by the House of Representatives and President Trump's statement that September would be the time for a "good" government shutdown if an acceptable agreement cannot be reached. A budgetary impasse and government shutdown would likely trigger higher equity volatility while likely supporting Treasury yields near-term. Brinkmanship could run high in the first full budget cycle under the new administration. Ultimately, a modestly stimulative budget agreement will likely be reached, but we expect the process to be contentious.

Debt Ceiling - Progress seems positive on an agreement to lift the debt ceiling, independent of the budget process, by at least $1.5 trillion by September 29th, the Treasury Department's deadline to avoid payment prioritization. A clean increase in the ceiling would remove some uncertainty that has had only a limited effect in the markets to this point. Increasing the debt ceiling should place upward pressure on Treasury volatility in the current environment. Failure to increase the debt limit in a timely manner would likely increase volatility significantly across the financial markets.

Tax Reform - The markets have been expecting tax reform since the U.S. election. While several market-based measures show fading hopes for reform, it remains a policy priority for the Trump administration and Congress. With the economy essentially at full employment, any stimulative benefits from tax reform will likely be met with tighter monetary policy in the near term. This should lift Treasury yields and volatility.

Quantitative Tightening - The Fed is set to begin reversing the quantitative easing program that has been in place since 2008. Likely to begin in September, the initial reduction is expected to be quite small, at $10 billion per month in maturing Treasury and mortgage securities. But the pace will likely increase to $50 billion per month by September 2018, absent disruptions to the financial markets or the economy. This will occur in an environment of slowing growth in the money supply and bank loans, and seems consistent with higher implied volatility for equities and Treasuries in the coming months. If financial conditions begin to tighten materially, any further monetary policy tightening would likely be halted, at least temporarily.

Fed Chair Appointment - It is uncertain who President Trump will appoint next year to lead the Fed. Reappointing Chair Janet Yellen would represent continuity and likely be welcomed by the financial markets. But the President is more likely to appoint a new Chair, which may cause uncertainty in the policy outlook. Potential nominees are unlikely to radically change the current policy approach, but a change in leadership would reduce certainty.

Foreign Influences - Aggressive easing programs by the European and Japanese central banks have likely helped lower volatility in domestic financial markets. Very low and stable global bond yields make U.S. Treasuries and other domestic assets attractive alternatives. This could change as the European Central Bank potentially further scales back its bond purchasing program next year.

Economic Growth Remains Steady

Overall economic performance remains in line with recent quarters, including slow and steady growth with ongoing job gains and limited inflation pressures. Gross domestic product (GDP) advanced 1.9% during the first half of the year. Employment reports over the past few months indicate firm labor demand. Overall labor market conditions continue to tighten, with the unemployment rate holding at a cyclical low of 4.3%.

Despite a tight labor market and easy financial conditions, inflation measures remain muted and longer-term inflation expectations are subdued. Nevertheless, the Fed will likely continue tightening policy, by reducing long-term securities holdings, until job growth has slowed to a level consistent with stable unemployment or financial conditions tighten enough (lower stocks, higher long-term yields and / or stronger dollar) to indicate some moderation in labor demand ahead. Markets continue give less than a 50% chance of an additional policy rate increase through the end of 2017 and suggest only modest adjustments thereafter.