Lewis Carroll, a 19th century English author, said “If you don't know where you are going, any road will get you there.” Rather than travel further down any of these roads to nowhere, the financial markets have decided to turn around.
Risk is back with a vengeance in the bond, commodity and stock markets. The benchmark, 10-year U.S. Treasury note now yields less than 3 percent, the Standard and Poor’s 500 index is off 8.5 percent since June 18, and major commodity indexes dropped 7.5 percent in just over two months.
The sharp rise in U.S. financial-market volatility is due primarily to rising uncertainty over future financial industry and market regulations.
Volatility rose dramatically in the U.S. financial markets last week. The Chicago Board Option Exchange’s index of stock market volatility, the VIX index, rose 40 percent, from 25 to 35 in late June. This index measures expected volatility in stock prices for the Standard and Poor’s 500 index over the next month.
The VIX is now trading in a range similar to that found during February and March 2009, a time of major political uncertainty over economic stimulus plans. Volatility also spiked during February and March of this year. At that time, the political uncertainty surrounded the new health-care legislation.
Most of the current stock market volatility is coming from the banking sector. The Options Insider reports that expected volatility in the financial sector of the S&P 500 Index rose more than 17 percent last week.
Today’s political uncertainty surrounds what is being called the Dodd-Frank financial reform bill. Sen. Chris Dodd and Rep. Barney Frank have negotiated a compromise bill that passed the House on Wednesday. But the bill’s fate in the Senate will not be known for awhile, as Senate leaders postponed the vote.
Nothing bothers financial markets more than the unknown.
Idaho Sen. Mike Crapo voted against the compromise and has indicated he will oppose the final legislation when it returns to the Senate. Crapo says, “The bill restricts access to credit and discourages capital formation in this country to work and yet once again creates a large, new, expensive government bureaucracy unreasonably extending the federal government’s control over the economy. The legislation also ignores reforming Fannie Mae and Freddie Mac, which stand out as the source of the greatest taxpayer losses and a root cause of the financial crisis.”
Key measures in this new legislation include a restriction on the ability of banks to invest and trade on their own behalf and new regulations for derivatives, contracts that derive their value from other financial assets like stocks and bonds.
The current bill does not, however, specify how the banks will be restricted or what amount capital banks will have to hold in reserve when trading derivatives. These important details will be determined at some future, unknown date by the “bureaucracy” of which Sen. Crapo warns.
The bill leaves the details for regulators at the Federal Reserve, the U.S. Treasury and various other agencies. Even if the bill is passed, these potentially devilish details will remain unknown for some time.
We don’t where we are going, or even what road we are on. Expect more market volatility.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.