WASHINGTON The sharp drop in the stock and commodities markets on Monday raised some critical questions for policymakers, touching on everything from whether asset managers are systemically risky to if the central bank would now delay raising interest rates.
The upheaval was not necessarily unexpected, as several analysts and even Federal Reserve Board Chair Janet Yellen had warned in May that she was concerned that U.S. stocks were "generally quite high."
Still, the volatility underscored several pressing issues regulators are grappling with.
Should Asset Managers Be Considered Systemically Risky?
Monday's sell-off was sparked by continued bad news coming out of emerging markets, particularly from China. On Aug. 11, the Chinese Central Bank made the surprise move of devaluing its currency, the yuan, adding fuel to concerns about the country's shaky stock market. The Chinese central bank has also been making moves to prop up values, but a slowdown in the country's manufacturing sector the biggest engine in the Chinese economy spurred the markets to fall still further in overnight trading.
Karen Shaw Petrou, managing partner at Federal Financial Analytics, said that the main concern coming out of Monday's rout was not related to stocks per se but related to the performance of emerging market mutual funds, leveraged emerging market exchange-traded funds and emerging market bond funds. If investors start pulling their money out of those kinds of vehicles which have been popular as investors have sought higher yields amid the low interest rate environment in the U.S. it could spur runs, which in turn could spread to other markets. Unfortunately, there is no way to know how exposed banks and asset managers are to those kinds of funds.
"Most of that is not publicly reported, so there's no way to tell that until markets close," Petrou said. "We've been seeing last night and, of course, last week -- some big redemptions."
Dennis Kelleher, president and CEO of public advocacy group Better Markets, said that while it remained unclear as of Monday whether those funds would underperform, the risk of broad devaluation of emerging market funds is a kind of "proof of concept" for the Financial Stability Oversight Council's argument that asset managers could pose systemic risk to the economy.
"You have the prospect for a very significant drop in prices and increase in volatility, and potentially a dramatic increase in investor redemptions within that sector," Kelleher said. "This is exactly one of the issues that FSOC has been concerned about, and it's exactly one of the [reasons] why FOSC was created. There is no doubt that FSOC is manning the battle stations today."
The Treasury whose secretary, Jack Lew, serves as chair of FSOC said in a statement that it had no comment on the market performance but that it was "monitoring ongoing market developments and is in regular communication with its regulatory partners and market participants."
Treasury has been examining whether asset managers pose a systemic risk, but the industry and the Securities and Exchange Commission have resisted such efforts.
Bob Eisenbeis, chief monetary economist with Cumberland Advisors, said that the concerns about a broad systemic downturn were overblown because the U.S. economy unlike many other places in the world is still fundamentally sound, and as such will likely remain the destination of choice for global capital.
"If you want safety, where are you going to go?" Eisenbeis said. "That means the exchange rate is going to appreciate. We don't do enough exports to make a difference as far as the real economy is concerned, and we buy, so we're going to get a price cut. What's going on in the rest of the world is a slowdown, but it doesn't have a lot of implications for us."
The Fed's Interest Rate Plans May Be on Hold.
The Fed has said all year that 2015 is going to be the year that it raises interest rates, though the target rate at year-end has moved substantially lower as the Federal Open Market Committee has passed each successive meeting without raising rates. The next meeting, scheduled for September 16-17, had been seen as the most likely liftoff point, giving the committee enough time to pull rates up to around .5%-1% by the end of the year.
But Yellen has repeatedly said that any increase in rates depends on conditions at the time the decision is made, and the market volatility and increasing concerns about emerging markets could be precisely the kind of conditions that could cause the committee to put off raising rates again.
Petrou said it was a foregone conclusion that the Fed is not going to raise rates in September, but said that the real question is whether the central bank will follow the lead of some European central banks and offer negative rates that is, charge depositors to take their cash out of the market. That scenario would be unprecedented and one for which the U.S. financial system is utterly unprepared, she said.
"Can they push rates negative? Would the Fed do that?" Petrou said. "I know some folks at the Fed who are looking into the abyss and thinking about it, because there's not a lot else they could do."
Eisenbeis had a different take. If the Fed raised rates, it could encourage overseas investors whose central banks were still offering near-zero interest rates to move their cash over the U.S., thus blunting the effects of higher rates on the near side of the curve. The Fed may opt not to do that, he said, simply because it doesn't want to add to a volatile market, but if it did the effects may not be as catastrophic as some may fear.
"Either way, it's simulative from a policy perspective," Eisenbeis said. "I do think that they'll be very cautious, because they don't want to add to volatility. But it's not obvious that that kind of move, or not moving, would."
Federal Reserve Bank of Atlanta President Dennis Lockhart said Monday that he still expects the central bank to raise rates this year, but dropped references to doing so in September. He cited the devaluation of the Chinese currency and a drop in oil prices as "complicating factors" in predicting the growth of the economy.
Will Regulators Crack Down on High-Frequency and Algorithmic Trading?
Regulators have become increasingly interested in examining the role that high-frequency or algorithmic trading is playing in the marketplace, and the abrupt and drastic drop in almost every market Monday morning is likely to draw regulators' attention.
The Treasury and other financial regulators recently published a post-mortem review of a flash event last October where Treasury yields spiked unexpectedly and drastically, only to come back down only minutes later and even out for the rest of the day. That analysis determined that there was no single cause for the event, but Antonio Weiss, Lew's top adviser, told the Brookings Institution last month that it is unclear whether electronic trading as it is currently practiced is making those kinds of flash events more common or more drastic than they might be otherwise.
"We need to be vigilant about events like that," Weiss said. "It did, of course, self-correct, but because it self-corrected the one time, you can't count on it self-correcting at some future date."
Whether algorithmic trading exacerbated the already low expectations for market performance is unknown and probably impossible to prove definitively, but the sudden and dramatic drop in markets followed by a volatile correction is a hallmark of algorithm-based trading strategies all moving rapidly in the same direction, Eisenbeis said.
"To what extent did program trading contribute to this downward move?" Eisenbeis said. "That just triggered a lot of this selling, and that raises some interesting issues about what you do about those kinds of systems at this point."