Traders came back to earth with a bump as markets ended their long bull run in dramatic style. Is worse yet to come? - AP
‘We knew something was coming. There was an eerie feeling to trading, it felt very wobbly,” recalls a City trader about a tetchy dealing room in London hours before the Dow Jones suffered its biggest one-day points fall in history.
“There were no buyers of anything and the older guys were warning, ‘this is going to collapse’.”
Anaesthetised by years of ultra-low volatility and stock markets that had climbed almost in a straight line, the younger heads on the trading floor, were chomping at the bit to “buy the dip” and pocket the profits when markets inevitably rebounded.
The Dow Jones – the US blue-chip index – plunged a staggering 1,000 points, or 4.1pc, in 21 minutes, shocking markets around the world.
Volatility returns
A potent combination of ultra-low volatility, which had bottled up risk, and the financial sector’s reliance on algorithmic trading made markets a lit match in a firework factory. The spark was provided by widespread anticipation that the Fed is about to pull away the “punch bowl” of low interest rates as the global growth party gets going.
The Dow’s 6.3pc intraday fall on Monday startled even the most sage commentators.
“I’ve been in the market for 55 years. I’ve seen big falls in a day but I’ve never seen ups and downs like that before,” says City veteran David Buik.
With the three benchmark American indices – the Dow Jones, S&P 500 and Nasdaq – soaring between 7.5pc and 8.7pc last month after a bumper 2017, the conditions were ripe for a sudden pullback.
“That is insane. At that speed under no volatility at all. It is a red flag, you’re going to get a correction whether you like or not,” Buik adds.
Yet market gurus have been increasingly calling for a “healthy” correction – a 10pc fall from an index’s 52-week high, highlighting US stocks as the overly frothy assets that most needed to let off steam.
Trumped up markets
The chorus of voices from the top levels of finance voicing their concern at complacency in markets has grown louder in recent months.
Citigroup boss Michael Corbat warned the World Economic Forum in Davos of a “numbness”. A downturn “is likely to be more violent than it would be if we blew off some steam along the way”, he said. Just 13 days later, the deafening silence on markets was finally broken. Wild swings between losses and gains gripped markets, rattled by the Dow’s freefall. The Vix, a measure of future expected volatility, also known as the “Fear Gauge”, had lain dormant since the devaluation of the Chinese yuan in August 2015 but erupted on Tuesday as stocks plunged. From a low of less than 10 points at the end of 2017, it soared to an intraday high of 50 points this week, the biggest one-day move in history.
A “sustained period of reasonably calm conditions” has fostered markets’ complacency, according to Lee Wild of Interactive Investor. “The US economy is performing well, inflation has been under control over the last couple of years and rates have been at ultra-low levels,” he explains.
While speculators can make a fortune from increased volatility, ING analysis shows that most spikes have been followed by a period of more risk averse markets with lower prices. Volatility is the lifeblood of short-term traders profiting from minute moves in prices but it puts everyday retail investors on a rollercoaster ride.
Global growth continues
“We love the volatility, it’s like a feeding frenzy,” says the trader as he buckles down for a turbulent few weeks. Products betting against volatility were the real source of the carnage on Wall Street, according to BlackRock strategist Isabelle Mateos Y Lago. Complacent investors pumped trillions into inverse exchange traded notes (ETNs) linked to the Vix Index.
The spike in volatility caused Credit Suisse’s Velocity Shares ETN, a fund worth £1.6bn less than a month ago, to shed more than 80pc of its value. It and Nomura both closed their Vix ETNs in the wake of the collapse in value.
“They are fundamentally unsafe but, of course if they were delivering hefty returns, warnings largely fell on deaf ears, so it’s become clear why they are not a good idea,” says Mateos Y Lago.
Investors’ ability to bet against volatility proved lucrative in 2017 but BlackRock warned the products do not “perform like exchange traded funds under stress”. The war among algorithmic trading machines is thought to have magnified the plunge on markets as computers sold off after passing what traders call a “technical level”.
Shouting traders in huge London trading rooms have been replaced by whirring machines making transactions at a speed well beyond the abilities of a human, and in a fraction of the time.
Computers scan news headlines for key words and make tiny adjustments in portfolios on every data release. Algorithms can boost the pound on a “soft Brexit” headline then send it sinking if inflation figures miss expectations, all in seconds. Computers were first introduced in trading in the Seventies and spread in financial centres globally in the late Eighties.
Central Banks normalise monetary policy
Today, approximately 60pc of stock trades are thought to be computer driven. Investors have drawn parallels between Monday’s flash crash and Black Monday in 1987. Computers are thought to have driven that record one-day plunge just over 30 years ago. Computerised portfolio insurance sold off stock index futures as the market plunged, with the feedback loop forcing equities even lower.
Algorithms also came under the microscope in October 2016 when a flash crash sent the pound to a 31-year low. Sterling dropped 6.8pc in minutes, rebounded, then ended the day 1.5pc lower. In 2010 US regulators found a single large trade caused the sudden slide in stocks when a poorly-designed algorithm’s actions caused a domino effect, leading to a 1,000-point swing.
Mifid II, the sweeping regulatory reforms to markets in Europe, has brought in closer monitoring to help stop computers being overloaded and driving volatility. But computers can’t be sentiment driven or hold reason in a crash. Their speed makes them hard to control.
“It’s a huge risk,” says Buik. “You’re allowing technology to dominate what should be fundamentals-driven.”
However, Bank of England Governor Mark Carney is not concerned about the return of volatility so far, arguing it shows that investors are beginning to factor in the return of stronger growth, inflation and interest rate rises. Markets are adjusting to those underlying changes in fundamentals in their thinking about what the Bank might do, and that is a healthy development,” says the Governor of the Bank of England.
“Yes it leads to a bit more volatility, but that is good volatility because nobody can predict what is going to happen in the future.”
Rather than panicking over a few days of choppy prices, he sounds more concerned by the prior boom in markets: “It certainly is healthier when markets have two-way risk around prices – you can have a trend, but a trend with two-way risk – and that holds for virtually any market including markets in volatility.”
As the head of the UK’s finance regulator, he is also keen to show threats in the financial markets are contained, insulating the wider economy. “The core of the system is in a different place to where it was, certainly prior to the financial crisis but stretching back over really a quarter of a century, so there is not the amplification from the core of the system of the volatility in markets,” Carney says.
“If anything, the core will help dampen it, so if markets need time to find the right levels and those levels include an appropriate level of volatility, that is a good thing because it is not being transmitted through the core and particularly to the real economy.”
Day-to-day movements in stocks tend not to affect the wider economy, but more serious falls can have an impact.
A fall in bond and stock markets makes it more expensive for firms to finance themselves, for example, and can trash confidence in an economy. “It would depend if the level is sustained or not. Five per cent lower equity prices tend to feed through into lower GDP growth of about 0.6 percentage points,” says Garry Young at Niesr, referring to the US economy. “But at the moment we don’t know if this is just market turbulence or something more significant.”
The return of some volatility does not worry Mark Carney too much just yetCredit: VICTORIA JONES/AFP
In the UK, investors may still be underestimating the Bank of England’s planned rate hikes. In part, this is because the Bank is changing its own forecasts. But also markets have proven reluctant to believe the era of ultra-cheap money is coming to an end, or even moderating partially.
Markets have priced in a UK base rate of 1.3pc by the end of 2019 – still well short of the roughly 3pc level that rates are expected to reach eventually.
“The question for central banks is, can they manage to withdraw some of the easy monetary policy of recent years without causing a very big fall in equity markets and potentially derailing the recovery,” says Stewart, noting global markets were rocked in 2013’s “taper tantrum” when the Fed indicated it would slow its money printing.
“This is probably the biggest single risk to the recovery.”
Much depends on investors’ ability to understand central bankers’ plans.
In the US, market expectations of hikes are still firmly below those set out by Fed policymakers, leaving room for more shocks if the Fed does as it says. Eager to clamber back up to euphoric heights, stocks could make exactly the same mistake again and dismiss the warnings of central banks.
