This guest commentary was written by Mike O'Rourke of JonesTrading on June 20.
The trading environment yesterday remained tranquil. The S&P 500’s intraday range was only 40 basis points, but trading volume was a mildly respectable 6.7 Billion shares. The S&P 500’s average daily range over the past two weeks has declined to 57 basis points, testing the levels of January and those that persisted throughout 2017 (chart below).
The year to date average daily range is currently 1.2%, the highest level since 2011, but it has been in steady decline since April. It appears as though 2017’s volatility vacuum is resurfacing. Over the past 20 years, the average daily range is 1.37%. Over the past 5 years, the average daily range has been 0.89%, while over the previous 15 years, it has averaged 1.53%.
If you exclude the Great Recession, the S&P 500’s average daily trading range in the decade prior was 1.42%. No matter how one examines the data, that is a dramatic shift in market behavior. It was a little more than 5 years ago when QE3 was launched and placed one of the most aggressively accommodative monetary policies in history on steroids.
Nine years into the economic expansion, Fed Chair Jay Powell talked about the strength of the economy today at the ECB Forum on Central Banking in Portugal. Powell noted:
“At 3.8 percent, the unemployment rate is below most estimates of its long-run level, which are now clustered in the mid-4s. Many other labor market indicators also suggest an economy near full employment. To name just a few, these indicators include an elevated level of job vacancies. For the first time since the Labor Department began collecting the data in 2000, there are now more job vacancies than there are people counted as unemployed.”
Powell reaffirmed his resolve to continue the policy normalization process and gradually remove accommodation. He reiterated the Fed Funds rate is still 100 basis points below neutral.
Powell also discussed the financial stability risks associated with the current environment.
“Can persistently strong economic conditions pose financial stability risks…But we have often seen confidence become overconfidence and lead to excessive borrowing and risk-taking, leaving the financial system more vulnerable. Indeed, the fact that the two most recent U.S. recessions stemmed principally from financial imbalances, not high inflation, highlights the importance of closely monitoring financial conditions.”
One could argue that signs of such risk taking are emerging.
Bloomberg reported today that Deutsche Bank’s “U.S. unit suffered a one-day loss in the first quarter that was 12 times what internal risk officers estimated for regulatory purposes it might lose on a typical day, according to a previously unreported May filing.”
Powell’s line about “excessive borrowing and risk taking” immediately comes to mind. Ironically, the bank has been designated as being in “troubled condition” by the Fed for more than a year, meaning the bank is subject to excess Fed supervision including risk taking decisions.
There is little doubt that the low volatility environment masks some of the financial hazards beneath the surface, apparently even from the Fed. We suspect this risk was exposed during the volatility explosion in February.
Lastly, Powell noted the last two recessions “stemmed principally from financial imbalances.” There is no doubt the Great Recession was the result of numerous simultaneous financial imbalances. What investors may find more interesting is that the principal financial imbalance contributing to the 2001 recession was the bursting of the equity market bubble.
This is a Hedgeye Guest Contributor research note written by Michael O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.