Volatility in financial markets in recent days has come after a remarkably long period of market calm. But this volatility isn't surprising, and we should expect the next year or so to see many more wild swings than what we've seen in the past two years.
The reason for the market calm for most of the past five years or so can be traced back to the global financial crisis, and central bank responses to the crisis after late 2008.
During late 2008 and early 2009 the global economy was in freefall, and central banks responded to this by cutting interest rates – in many cases to near zero – and by providing liquidity and other support to markets, often through quantitative easing (purchasing assets).
One of the aims of these central bank actions was to prop up equity markets. Ben Bernanke, then chairman of the United States Federal Reserve (the Fed), claimed that strong equity markets supported wealth and spending in the economy, and so would aid recovery.
"I would expect to see most central banks raising at least twice this year, and this is likely to drive market volatility."
This central bank support has gone on for much longer than many economists would have expected. Interest rates in most countries are at historic lows, and have been low now for nearly a decade. These low interest rates continue to keep equity markets high.
Low interest rates have two effects on equity markets. Firstly, interest-bearing assets (bonds) and equities are alternative asset classes in which to invest, and if interest rates are low, that makes it more attractive to invest in equities. Secondly, ultra-low rates should make it attractive for firms to borrow, and support investment and firm profitability.
Since 2009, every time there's been a change in policy from central banks, equity markets have gone into a tantrum. The ‘’taper tantrum” of 2013 saw the Fed starting to reduce quantitative easing, and financial markets went into a brief tizzy then.
The new normal
In the past year or so, many central banks have warned about the need to “normalise” interest rates. What normal means is debatable, but in the case of Australia, interest rates at least two or three per cent higher would be closer to what most economists consider to be normal.
The problem for central banks is that every time they start to move towards raising rates, the markets go into a frenzy, and central banks have to some extent been getting cold feet as a result.
The world economy is, however, now at a stage where central banks really do need to start to raise interest rates.
The US economy is doing reasonably well, and even Europe, the global laggard in recent years, is showing respectable growth. So I would expect to see most central banks raising at least twice this year, and this is likely to drive market volatility and perhaps market falls. The big question for financial markets is whether the economic recovery is strong enough to offset the impact of rising interest rates. If so, markets will continue to bubble along, but if not markets will fall.
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