• A correction in equity markets finally surfaced in February due primarily to concerns of rising inflation, higher long-end rates, and tighter monetary policy
  • S. retail sales data were softer in January, but business sentiment, inflation, and labor market data continued to match/surpass expectations
  • Fed leaders have suggested the sell-off is “small potatoes” from a big picture perspective, and gradual normalization is still the plan

After an effective 12+ month nap, volatility returned to global risk markets in February. For much of 2017 and the first month of 2018, equity markets seemingly traded in one direction. However, in the first week of February, a correction in equity markets finally surfaced. In our January commentary, we noted that a common concern among top equity investors was rising inflation expectations and long-term bond yields, particularly as it affects stock valuations. The 10-year Treasury yield rose 30 basis points (bps) in January on improved wage and inflation data, higher commodity prices, and more hawkish rhetoric from the European Central Bank; by February 2, the 10-year yield was up another 15 bps to a 4-year high. The move in long-end rates was the primary catalyst for a major sell-off in U.S. stocks, and the next Monday, the Dow Jones Industrial Average fell more than 1,100 points (4.6%). At the same time, implied volatility in equity markets exploded higher (see Exhibit 1). The VIX index tracks S&P 500 options on the Chicago Board Options Exchange, and on February 6, the VIX breached 50 for the first time since the end of the credit crisis. By the middle of that week, the S&P 500 had fallen more than 10% from the recent peak on January 26.

As February progressed, volatility subsided somewhat, and equity markets bounced 5% higher from the February 8 low. That said, anxiousness remains in the markets, which is to be expected following a correction. The economic data trend remains positive, although some recent reports have been softer. Specifically, the retail sales control group, which is used in the GDP calculation, was unchanged in January versus expectations for a 0.4% increase, and the December growth figure was revised lower by 50 bps (-0.2%). Surveys of business sentiment remain relatively robust, and on the inflation front, January core CPI was above expectations at 0.3% m/m (1.8% y/y). Additionally, recent labor market data revealed further signs of a tighter job market, with the 4-week moving average of initial jobless claims reaching another new 49-year low in February.

The February pullback in stocks predictably sparked questions regarding its impact on Fed policy. During the Alan Greenspan years, the Fed injected liquidity into the markets during several episodes of equity market volatility, which became known as the “Greenspan put” by traders (also termed moral hazard). Ben Bernanke seemed to follow his predecessor’s lead (albeit under extraordinary circumstances in the wake of the financial crisis), and in 2011, he touted that the Fed’s post-crisis policies had “contributed to a stronger stock market.” Some market participants joked that the Fed now had a third mandate of supporting equity market valuations.

On February 7, New York Fed President Bill Dudley was asked what impact that week’s equity sell-off might have on Fed policy. Dudley was largely dismissive of the implication, calling the week’s events “small potatoes.” The interviewer reminded Dudley of the Fed’s propensity to react to previous episodes of equity weakness (the “Greenspan/Bernanke put”), specifically in 2016 when the Fed paused its rate hikes for 12 months. Dudley countered by noting the very different landscape at the time (slowing global economy, falling commodity prices, etc.), and current anxiousness in risk markets is more attributable to higher growth and inflation expectations, as well as expectations for reduced monetary accommodation. In his first appearance before the House Financial Services Committee as the new Fed Chair, Jerome Powell maintained an optimistic tone with his economic outlook, and his policy comments were generally perceived to be hawkish. As such, it would not be a major surprise to see the updated Summary of Economic Projections (SEP) on March 21 to forecast four rate hikes in 2018 (up from three last December). The markets have priced a 100% probability of a March rate hike since February 7, and futures markets are effectively fully priced for three hikes in 2018.

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