Return of Volatility Foreshadowed In Economic Data

(Bloomberg View) -- If financial market volatility was given up for dead in 2017, then get ready for a resurrection. To understand why, take a look at the incoming economic data. When the underlying dynamics of the economy change, the data tend to become more volatile before markets react.

Economic volatility as expressed by the standard deviation of changes in the monthly data has been on the rise since the summer as the global economy gained strength. Financial market volatility, though, has fallen amid a lack a surprises in central bank policies, receding geopolitical tensions and upbeat corporate earnings. But as history shows, such divergences between economic and financial market volatility only last for brief periods. As such, a rebound in market volatility has the potential to be a key driver of risk premiums, bond yields and valuations in 2018.

Economic Volatility Versus Market Volatility

Volatility is also linked to "financial vulnerability," which is an aggregate of indicators such as fiscal and current-account balances, the share of local currency bonds held by nonresidents, and short-term external debt as a percentage of currency reserves. Such vulnerabilities picked up in 2017 as portfolio flows into local emerging-market bond and currency funds swelled by $7.5 billion to 15 percent of local gross domestic product with the growing popularity of exchange-traded funds.

And although the data coming from emerging-market economies have been solid, it's become more volatile, which contrasts with the drop in financial market volatility brought on by large portfolio flows. Countries such as South Africa and Turkey that are political hot spots have seen portfolio flows increase even though their current-account balances have deteriorated. Historically, market volatility has closely tracked economic volatility in emerging markets.

Emerging Market Economic Volatility and Market Volatility

Volatility may also resurface along with political uncertainty. The biggest surprises in politics this year were that the Dutch and French elections turned out positive for markets and the risks emanating from North Korea turned out to be not so dire. That only served to bolster the perception among investors that political events are having less of an impact on markets, further lowering volatility.

Political events next year such as the Italian elections, which may happen in March, and the U.S. midterm elections, could change that way of thinking and spark higher volatility if the outcomes surprise. There are also big questions concerning monetary policies as central banks become less accommodative. The current thinking is that monetary policies will normalize gradually, but that could change with a shift in the economic data.

Policy Uncertainty and Volatility

There is always a long list of items that could spark volatility. Where volatility is likely to show up first is in the foreign-exchange markets. Already, the difference between one-month and one-year implied volatility has begun to widen in both developed and emerging markets. That shows although economists and investors celebrate the global economic synchronization story, the currency market has its doubts and is placing a bigger premium on volatility picking up.

Currency Volatility Spreads

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ben Emons is chief economist and head of credit portfolio management at Intellectus Partners LLC. The opinions expressed are his own.

To contact the author of this story: Ben Emons at bemons8@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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