No Wonder Mario Draghi Warns of Market Volatility

Monitor with interest rate increases showing.

ECB president Mario Draghi’s advice last week for markets to “get used to periods of higher volatility” is aptly timed. The past week saw bouts of exceptional volatility in financial markets, with equities, bonds, and currencies experiencing some very sharp swings, writes Oliver Mangan Chief Economist at AIB.

It is a continuation of a trend evident in recent months, marking the end of a long period of directional trading in fixed-income and forex markets.

The normally stable German bond market led the way in volatility last week. Ten-year bund yields started the week at 0.5% before doubling to nearly 1%, then falling back to around 0.85%, with some very large inter-day swings towards the end of the week.

Within this volatility, though, there has been an underlying trend of curve steepening in the past two months. In other words, although short-term interest rates have hardly moved and remain very low, longer-term interest rates and yields are moving higher.

The reasons for this are multiple. Fears about deflation are abating as inflation starts to rise again on a moderate recovery in oil prices. Last week saw data showing that eurozone inflation turned positive in May for the first time in five months, with the annual rate coming in at +0.3%.

Meanwhile, eurozone bond markets are unwinding from extremely over-bought levels that saw 10-year German bund yields fall as low as 0.05%. These yield levels were simply too low to be sustained.

The markets are also positioning themselves for a hike in interest rates by the US Federal Reserve later this year. This would be the first US rate hike in nearly a decade. There has been a belief that the start of the process of normalising official interest rates could cause some dislocation in financial markets.

Another factor contributing to heightened market volatility is poor liquidity. In an era of risk avoidance, greater capital requirements, and increased regulation, the big investment banks have greatly scaled back their market-making activity in fixed-income markets.

The impact of this has been particularly noticeable in recent times, with a marked deterioration in liquidity when markets come under significant downward pressure.

In these circumstances, even small trading volumes can generate big price swings.

The action on currency markets in the past week largely mirrored the moves in bond yields. The euro made big gains on the back of the sharp rise in bond yields, which was most pronounced in the eurozone. However, it then lost ground on strong US labour data on Friday.

Despite the extreme volatility last week, key exchange rates remained within the well-defined trading ranges evident in recent times. The euro continues to trade in a 70p-74p band against sterling and $1.08-$1.14 versus the dollar.

With the ECB having set out its policy stall until well into the second half of next year, and the Bank of England very much on hold, market attention is focused on what the US Fed will do over the second half of the year. US monetary policy has the potential to cause further volatility in financial markets in the months ahead.

Indeed, further market volatility may be inevitable. If, as we expect, the US Fed starts to hike rates, there is the potential for further disorderly adjustments by markets as they come to terms with a new paradigm on interest rates and look to gauge by how much rates will rise.

On the other hand, a continuation of zero interest rates could see increased risk taking and leverage, leading to even more stretched valuations in markets. This is a recipe for disorderly market trading, with rallies and severe corrections, as we saw in the past week.

It is little wonder, then, that Mr Draghi has warned markets to get used to periods of higher volatility.