Everyone understands that Washington’s current budget battle will create near-term market volatility. But many market watchers expect the volatility to be a temporary phenomenon that dissipates as soon as this latest episode of the fiscal soap opera is over.
I don’t agree. In my opinion, there’s a good chance that recent volatility may be here to stay for the long term. Here’s why:
Volatility over the past year has been unusually low. Most investors enjoyed a relatively quiet summer. In fact, since the fall of 2012 – with the exception of a brief scare last December around the fiscal cliff – US market volatility has generally been well below average, at least compared to the last twenty years. This is true regardless of the measure used, and the same holds for many other developed markets as well.
Part of the reason lies with monetary policy. The combination of the Federal Reserve (Fed)’s QE3, the European Central Banks’ OMT, and the Bank of Japan’s asset purchase program has gone a long way towards placating investors and suppressing market volatility.
The budget battle is likely here to stay for a while. Another reason for the past year’s low volatility: Other than the brief scare last December, there were few political or policy issues to rattle markets. In other words, there is a link between political and policy risk and market volatility. As you would expect, higher uncertainty over policy tends to be associated with more market volatility.