Worried About the Stock Market? This Is Just the Beginning.

Traders work on the floor of the NYSE in New York

The U.S. financial markets will become increasingly volatile as interest rates rise and credit spreads return to something approximating normal.

By holding down bond yields and, indirectly, compressing credit spreads, the Fed and other central banks have reduced actual volatility and, more important, also gradually reduced the market’s expectations for future movements in the prices of securities. Thus, on Monday investors got a very big shock indeed when market prices started to fall after years of a sustained and very artificial bull market.

Not only has former Federal Reserve Board Chair Janet Yellen and her colleagues on the FOMC created a time bomb of volatility in the U.S. bond and equity markets when it comes to risk, but the extended period of low-interest rates has also created a hidden wave of future loan and bond defaults.

By suppressing credit spreads and thus the cost of credit, the FOMC afforded interior corporate and individual borrowers access to credit at premium, investment grade prices. Now corporate and consumer debt defaults are starting to accelerate. “For the first time since January 2017, the default rate for autos, bank cards and mortgages all rose together,” says David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices.

Over the next year and more, the U.S. financial markets will become increasingly volatile as interest rates rise and credit spreads also return to something approximating normal. Borrowers who could access credit at ultra-low rates will find themselves constrained, both by the cost of credit and the willingness of investors to take risk. And retail investors who have purchased the plethora of derivative such as exchange traded funds will face a very dangerous market environment.

Investors, after all, dislike change and love risk-free returns. As the FOMC attempts to normalize policy after almost eight years of extraordinary market support, the equity markets are likely to retreat—especially with the Treasury ramping up its borrowing schedule. Each incremental increase in interest rates gives investors a greater incentive to take their profits off the table in stocks and move back to the relative safety of Treasury securities. For new Federal Reserve Chairman Jerome Powell, 2018 is likely to be a very challenging year indeed.

Richard Christopher Whalen is an investment banker and author who lives in New York City. He is Chairman of Whalen Global Advisors LLC and focuses on the financial services, mortgage finance and technology sectors.

Image: Reuters

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