Charles Schwab: Tightening Financial Conditions, Monetary Policies Add to Volatility – Investopedia (blog)

While much of the stock market volatility has been blamed on uncertainty about interest rates, President Donald Trump’s tariff proposals and the potential for inflation to pick up, Charles Schwab Chief Investment Strategist Liz Ann Sonders says that tightening financial conditions and monetary policies across the globe are also playing a role.

In a blog post this week, Sonders said that, while tightening financial conditions in lock step with tightening monetary policy have not been listed as the main reasons for the increase in volatility and weakness in stocks this year, these factors will continue to be important “fundamentals” for stocks. The strategist from The Charles Schwab Corporation (SCHW) noted that, not only are short-term interest rates moving higher thanks to the Federal Reserve actions since December 2015, but longer-term rates are also on the move higher.

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But it’s not just rising interest rates that have Sonders concerned about the impact of monetary policy and tightening financial conditions on equities. Sonders pointed to the shrinking of the Fed’s balance sheet, which kicked off last fall. She said that the run-off in Treasuries is capped at $18 billion per month but that, in the first quarter of 2018, there were two weeks when the combined liquidity provision of the Fed and the European Central Bank was negative. According to the Schwab strategist, this was due to the balance sheet of the Fed shrinking more than the ECB’s balance sheet expanded. What’s more, the European Central Bank is expected to end its quantitative easing program by the end of this year. That, said Sonders, will make liquidity contraction “the norm instead of the exception.”

In addition, Sonders said that the Fed’s rate actions during the cycle have resulted in the two-year Treasury yield rising. At the same time, the three-month London interbank offered rate, or LIBOR, has been rising rapidly, with the spread between LIBOR and the overnight index swap, or OIS, increasing to the highest level since the end of the last recession. Sonders said that the spread is a measure of how cheap or costly it is for banks to borrow money. She noted that the “blowout” in LIBOR-OIS is an additional sign of tightening financial conditions that will add to stock market volatility.

“Higher rates, tighter financial conditions and the blowout in the LIBOR-OIS spread likely don’t represent individually or collectively systemic risks to the economy or the stock market,” wrote Sonders. “But they are clearly a symptom – as is higher equity market volatility – of a wider rerating of credit. Volatility is likely to remain high this year and investment discipline remains essential.”

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