As global alignment on interest rates collapses, expect more volatile markets

Recent actions from central banks around the world signal a new era of monetary policy … and, perhaps, higher levels of market volatility.

Expect volatile markets for the foreseeable. Pic via Getty Images

Recent actions from central banks around the world signal a new era of monetary policy. The period of globally coordinated policy that began with the 2008 financial crisis and extended through the 2020–2022 Covid-19 restrictions, is over.

Instead, the world is returning to the ‘normal’ conditions that preceded the Global Financial Crisis.

Central banks’ focus is returning to the domestic factors that drive each country or region, determining monetary policy largely on local rather than international concerns.

This change in approach from reserve banks is likely to affect market conditions in many ways. Perhaps the most important possibility for investors to consider is for markets to return to more ‘normal’ or higher levels of volatility.

To see the increasing importance of domestic, not global, issues in determining monetary policy we need only look at the most recent examples.

Nations go it alone on setting rates

In the US, the Federal Reserve flagged well ahead of time its intention to reduce the federal funds rate. Its deep cut of 0.5% was received as a statement of intent – analysts interpreted the move as a sign the Fed is refocusing from previously sticky inflation to softening employment conditions.

Lower rates can help support the economy. The Fed maintains it is guided by data, and so traders are pricing a reduction from the current federal funds target rate of 5% to levels below 3% by the middle of next year.

In contrast, Bank of Japan policy board member Junko Nakagawa said "given real interest rates are currently very low, we will adjust … if our economic and price forecasts are met".

Many read this as maintaining a tightening bias, while echoing the data dependence of the US Fed.

Similarly, despite clear expectations of further significant reductions in the US, the Bank of England governor struck a different stance, saying “we need to be careful not to cut too fast or by too much” and that it is “vital that inflation stays low”.

Another possible divergence may be occurring in Norway, where Norges Bank governor Ida Wolden Bache stated it will keep the policy rate at 4.5% until the end of the year.

This breaking up of central bankers’ global co-ordination may fly under the market radar at the moment. There’s a good example in Australia.

On September 5, Reserve Bank governor Michele Bullock stated it would be “premature” to cut rates. The speech was entitled “The Costs of High Inflation”.

Despite such clear indication the RBA remains focused on fighting inflation, and local money markets are pricing an interest rate reduction by February.

Expect more volatile markets

If traders and investors come to a sudden conclusion that Bullock is right, a whiplash in interest rates could quickly spread to the sharemarket.

It’s not just that higher interest rates reduce share valuations, and higher borrowing costs hit corporate profits. The secondary effects of higher interest rates could include a higher and rising Australian dollar, hurting miners and other exporters.

This makes this week's meeting of the RBA board crucial for the short-term market outlook. While leading in, there was very little possibility of a change in cash rates in either direction (Ed: and so it proved), a convincing statement that has markets wondering about the potential for tightening in Australia could hit the sharemarket hard.

Regardless of the RBA’s words this week, global markets could be heading for choppier waters. One of the features of the financial world from 2010 through to 2023 was low market volatility. While some individual shares remained volatile, at the index level sharemarkets went through an historic low. The same was true for currency and energy markets.

One theory is that the oceans of cash pumped into the global financial system by central banks underpinned markets and reduced downside volatility.

Investors may have been less concerned about the risks of stock ownership, their concerns eased by the “Fed put”.

Additionally, the similarity between monetary policy regimes meant the elimination of one of the key drivers of currency movement – changing interest rate differentials between currencies.

All of these cushioning factors may be eliminated as central banks tune into their domestic situations more closely. Higher volatility can bring higher share prices as upswings become more extended, but this potentially means greater reward seesawing with deeper share price falls.

It’s possible that markets will easily adapt to this change in the way central banks set policy. Fresh all-time highs by many global sharemarket indices suggests a degree of nonchalance about this sea change in global monetary policy.

However, a sudden dawning of realisation could trigger substantial market moves. Investors may do well to prepare for higher volatility and choppier trading conditions while conditions are calm.

Michael McCarthy is chief commercial officer at moomoo Australia.

The views, information, or opinions expressed in the interviews in this article are solely those of the contributing author and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.

Originally published as As global alignment on interest rates collapses, expect more volatile markets