Many investors are familiar with the adage, “they don’t ring a bell,” to warn when it is time to get in or out of an investment. Well, sometimes they do, or so the famed scientist Ivan Pavlov would likely contend. The physiologist trained dogs to salivate at the sound of a bell, having conditioned them to associate the bell with the delivery of food. Pavlov discovered that he didn’t actually have to deliver the food to get the canines to salivate in anticipation.
It is no different in markets, where the anticipation of an event can invoke the same response as the real thing. Market participants seek to discount the future, after all.
In 2015, market volatility has been rooted in a phantom rate hike from the Federal Reserve, which throughout the year has been ringing a bell to warn markets that it is on the verge of raising interest rates for the first time since 2006. Though it hasn’t happened, the Fed has elicited a typical Pavlovian response, causing markets to shudder at the thought and prompting a very significant chain of events that has rippled throughout global financial markets. While anticipation of the Fed’s rate hike isn’t the cause of market volatility, it has been a catalyst.
How the greenback turned markets redThe chain of events began, as we noted in the April publication of the Global Central Bank Focus, with a rise in the value of the U.S. dollar at the end of 2014 (Figure 1). The ascension was predicated upon the idea that global central bank policies would begin to diverge, with the Federal Reserve expected to raise interest rates at a time when the rest of the world and, in particular the developed world, was still in the midst of providing new monetary accommodation. This started the ball rolling. Yet, there was no actual rate hike.
The strengthening U.S. dollar and the anxious anticipation of a Fed rate hike by investors throughout the world sparked a cascade of events, all inextricably linked. One of these events has been a decline in commodity prices (Figure 2), which often fall when the dollar strengthens. The decline hurt markets in commodity-producing nations, including many in the emerging markets. Declines in commodity prices and attendant weakness in emerging markets has dominated markets this year, spilling over into developed markets by weakening equity markets, widening credit spreads and suppressing interest rates....