MARKET THEMES13/07/2021

Inflation, rather than Covid, is driving market volatility

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Inflation, rather than Covid, is driving market volatilityInflation, rather than Covid, is driving market volatilityInflation, rather than Covid, is driving market volatility

Vaccination progress and strong economic data have eased the effect of Covid on market volatility. However, rising inflation caused a spike in the VIX Index. The next few months will be difficult to predict and could bring trading opportunities.

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4 min reading

Market volatility remained at its lowest levels in a year in April 2021. This was a reflection of diminishing concern about the impact of Covid-19 and some punchy economic data. Only inflation threatened to ruin the party.

Market volatility updates showed less focus on the virus

Markets are no longer minutely observing case numbers and vaccine rollout data. Even the emergence of the aggressive Delta variant of Covid-19, with its ghastly impact across India, did little to disrupt market optimism. With many of the world’s largest economies well-advanced in their vaccine programmes and economic activity resuming, there appears less fear of a broader resurgence.

For the time being, the data is good on the existing range of vaccines’ efficacy on the different variants. Equally, most vaccine providers appear optimistic that they could tweak their formulas to cope. Of course, markets remain vulnerable to a vaccine-resistant strain of the virus.

Inflation could be an issue for market volatility

The April inflation print of 4.2% for US CPI was the sharpest increase since 2008, unnerving investors and leading to a spike in the VIX Index. Although the Federal Reserve stuck with its line that inflation pressures would be temporary, markets worried that the central bank may have to backtrack on its commitment to keeping interest rates lower for longer.

While this created some temporary volatility, markets had recovered their equilibrium by early June. May’s inflation print, which, at 5% was even higher, produced barely a ripple. The 10-year bond yield, which had risen sharply in the first quarter, started to move lower again.

In its June meeting, the Federal Reserve appeared to acknowledge tacitly that inflation could be a problem. Its ‘dot plot’, which records anonymously the expectations of individual members of the Open Market Committee, showed the majority now pricing in two rate hikes in 2023. This spooked markets once again, leading to a small sell-off in the stock market and a small rise in the 10-year treasury.

The Federal Reserve is sticking to its prediction that inflation will fall back to 2.1% in 2022. However, there are still plenty of economists who disagree, pointing to bottlenecks in supply for specific commodities and semiconductors, plus labour shortages. Businesses are increasingly being forced to pay higher wages to attract staff. This may ultimately lead to structural wage inflation. Overall, inflation remains a major source of market volatility.

Encouraging growth figures suggest a global economic recovery

In May, UK businesses reported the fastest growth in activity in more than 20 years with the IHS Markit/CIPS flash UK Composite Index rising to a record high of 62 (50 indicates expansion).

Purchasing Managers’ Index data from the US - a measure of the direction of economic trends in manufacturing and services - registered 70.1 for the services sector, up from 64.7 in April as the country unlocked and people rushed back to leisure activities. Chris Williamson, chief business economist at IHS Markit, commented that: “The US economy saw a spectacular acceleration of growth in May, the rate of expansion of business activity soaring well above anything previously recorded in recent history as the economy continued to reopen from Covid-19 restrictions. The service sector saw an especially impressive surge in growth, beating all prior records by a wide margin, accompanied by another solid expansion of manufacturing output.”

While the US and UK appear to be coming out of the blocks fastest, there is still encouraging data emerging from Europe and Asia. Admittedly, figures are flattered by weak comparative data and the effect of unlocking. However, they remain encouraging.

For traders, it is worth noting the bumpiness of some of the figures. In some cases, they have come in significantly ahead or behind market expectations. This situation is unprecedented and therefore analysts’ models may prove inadequate which may create trading opportunities.

Inflation movement is influencing currency pricing

The gold price has been bouncing around as investors try to decide whether its role as an inflation hedge outweighs the potential for future rate rises. It appeared to be benefiting from a widespread move out of Bitcoin and other cryptocurrencies, which have been sliding since early May. However, this rise tailed off in June as US interest rate rises became more likely.

The Dollar reversed its rise earlier in the year. It had defied widespread expectations of a fall, largely as a result of rising interest rate expectations, but it started to slip again from March onwards as fears receded. However, the recent subtle shift from the Federal Reserve may see it reverse direction once again.

Financial markets appear to be putting the pandemic behind them, instead turning their attention to inflation and interest rates. This may become a dominant market volatility theme for the remainder of the year.

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