We have passed through the US-based Labor Day holiday – a seasonal drought in broader market liquidity. This go around, the slump in participation exacerbates a deepening, structural drain in market activity born of monetary policy and the complacency that follows it. The question traders and investors should ask is whether the reliable seasonal tides can marshal in a deeper current change for the global financial markets that resolves stubborn moral hazard and desperation for return.
On the ‘seasonal’ side, we have the historical norms that rise and fall normally year-after-year for the markets. It is a general expectation that we see a change in the developed markets from quiet summer trading months to a more active fall. That is borne out in statistical averages. Below, we have a chart of the VIX volatility index and its average level on a monthly basis going back over the past 25 years. While the reading has risen through August historically, it shows a distinct peak in September and November. The activity measure has lagged the normal course of past years in 2016 through July and August, but the pressure is still building.
From the – a measure I consider a good reflection of ‘the market’ owing to its accessibility across all types of market participants – we can see another distinct norm: volume starts to rise from the extreme lull in volume and September is notably a down month on average. Volume is turnover or participation (essentially the market depth to give body to deeper change) and we are coming off the lowest ‘regular’ month of activity of the year. It is the index’s performance however that stands out as remarkable. September is historically, the only month of the calendar year that has averaged a loss.
September is a long month. Does the seasonal change take root with the US Labor Day holiday passing or does it play out later in the extended period? Below we have a normalized view of the VIX volatility index to see what the activity measure has done over the past 10 years. The purple line represents the average outcome while the gray lines show the maximum and minimum (normalized to 60 days before Labor Day) through that decade. Volatility does not typically flip from quiet to exceptional activity, rather activity seems to build with time. It is also worth noting that for 2016, we are exceptionally quiet – and that is saying a lot given the comparison being made.
Another measure of market activity can be derived from the average range of a representative benchmark. Again, I chose the S&P 500 and use a 20-day average true range (ATR) to express the historical conditions as well as our current condition. We can see much the same as what is reflected in the VIX: that a surge in activity is not necessarily the norm heading into the first week to follow the US holiday and that we are currently on path for an extreme quiet.
The greater hurdle to recharging the market is not the seasonal restraints that we have to work out and build confidence around, but rather the deeper counter currents working against the market. Over the past few years, we have seen an extreme drain on market participation born of the extremely deflated expectation of return that have resulted as an unavoidable side effect of the accommodative monetary policy that central banks have pursued to compensate for the lack of fiscal and structural progress around the world. Below we can see the cumulative notional balance sheet growth of the Federal Reserve, European Central Bank, Bank of Japan, Bank of England and People’s Bank of China compared to the VIX volatility index. This is a force that has generated considerable force, but is not boundless.
What many central banks – or at least select members from their rank – are starting to admit to is a waning effectiveness of monetary policy at the extremes. We have seen the , Yen and now the offered distinct evidence of the diminishing return of ever-expanding balance sheets. As this policy influence evaporates, the suppression of volatility and buoyancy on speculative appetite erodes with very unnerving potential consequences for the global financial system and economy.
As always, there are multiple scenarios that we should entertain as traders. Risk appetite can find a sudden swell or collapse with the proper motivation. However, there are certain historical conventions which are difficult to escape. One such line of influence comes between the performance of markets, volatility measures and participation. There is a distinct, inverse correlation between volatility and risk-oriented markets (like the S&P 500).
That should make sense as many pursue such markets for consistent and low volatility returns. That said, there is also a strong relationship between volume and volatility – as can be seen below. It can be argued that volatility follows volume or vice versa, but the relationship is nevertheless strong; and that does not bode well for the ultimate outcome for the next motivated move in speculative markets.
What is lacking for the transition from quiet to active market is a motivation. A catalyst is certainly necessary as complacency is particularly strong in current market conditions. The question is what motivates moral hazard that is made tangible through need (a need for yield). The typical seasonal shift may not be enough to single-handedly motivate the change, but it can be the start in a chain reaction. Concerns that monetary policy are losing traction or even drawing greater skepticism can render key central bank decision milestones for doubt and therefore deleveraging. Perhaps the spark will be less scheduled – like the rise of a concentrated financial crisis – but what is clear is that the risks are far greater and material than they have been in past months and years.