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Monday’s market volatility reflects the new economic reality. Here’s how

The sell-off that hit Wall Street on Friday whipsawed the market again on Monday. In one furious, 15-minute stretch, the Dow dropped and recouped 700 points. What made markets plunge? John Yang gets analysis from Gillian Tett of the Financial Times and Diane Swonk of DS Economics.

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  • John Yang:

    What a long, strange day it was on Wall Street. The sell-off that began Friday whipsawed the market again.

    In one furious 15-minute stretch, the Dow Jones industrial average dropped and then recouped 700 points. It ended with a loss of 1,175, to finish at 24,345. That’s a drop of more than 4.5 percent, the biggest percentage drop since 2011. The Nasdaq fell 273 points, and the S&P 500 gave up 113.

    We try to sort some of this out now with Gillian Tett, the U.S. managing editor at The Financial Times, where she is also a markets and finance columnist, and Diane Swonk, chief economist for Grant Thornton in Chicago.

    Thank you both for joining us.

    Diane, let me begin with you. What happened today?

  • Diane Swonk:

    What we’re starting to see is reality finally hit into the fact the markets were priced to perfection, and the economy is not perfect.

    In fact, we sort of saw a sort of euphoria almost like 1999 out there with this roaring stock market, but we have got a 21st century economy, an economy that’s doing well, but it also has a price to that stronger growth, and that’s higher interest rates.

    That’s something the markets hadn’t counted on, is that not only are we going to see some inflation going forward, but with the warming trend in wages, we will also see higher long-term interest rates, and that’s just a cost of a better economy.

  • John Yang:

    Gillian Tett, reality setting in?

  • Gillian Tett:

    Absolutely.

    I was in the World Economic Forum just a few days ago in Davos talking to CEOs and hedge fund traders. And the comment that almost everyone made is, this cannot last, it’s too good to be true to have the equity markets rallying day after day and to have the volatility, the amount the markets swing each day, so incredibly low.

    And what sparked this latest sell-off really was a realization on Friday that we’re just starting to see the first signs of inflationary pressures creeping into the U.S. economy, and that left many traders thinking, well, actually, these extraordinary conditions that have been supported by cheap money from central banks, that can’t go on forever.

  • John Yang:

    Diane, but we have seen this, employment numbers getting better, wages getting a little better and last month the big tax bill being passed. We knew that there was going to be a lot of borrowing ahead. Why did it suddenly come into focus now?

  • Diane Swonk:

    Well, I think there’s a lot of things. One is that employment report on Friday, today’s report on the service sector doing as well as it has since 2005.

    Those things altogether suggest that the economy is finally experiencing a warming trend, that the sort of Goldilocks scenario that the world would be forever with low interest rates and low wages for Wall Street, now we’re shifting the baton to Main Street a bit, although I think the wages are still a hope. We still need sustained wage gains out there, but that reality set in

    Also, this is a global phenomena. I think that is very important is that other economies are also picking up, and you’re seeing other central banks not only lift their foot off the accelerator, but talk about hitting the break. This is a very big shift from what we have seen for the last sort of eight to nine years.

  • John Yang:

    And, Gillian, you talk about that volatility. The selling really increased in the afternoon. It slacked off a little bit, but then increased again at the close. Is this an indication of program trading?

  • Gillian Tett:

    Absolutely.

    One of the really important things to understand is that, right now, people reckon that about almost half of all the money in U.S. equity funds are in passive funds. That means there’s not a human involved in actively managing them. It’s computers.

    And on any given day, you can get sometimes two-thirds of the market driven by computerized trading. And a lot of these computerized programs are essentially set up to sell when conditions get very choppy. Everyone talks about self-driving cars. What we’re kind of seeing is self-driving markets where a lot of computer programs are jumping in.

    And in addition to this, there is a particular trade that’s been incredibly unpopular for the last few months called trading on volatility, basically placing bets that volatility is going to be carrying on being very, very low in the markets.

    What happened in the few hours at the end of stock market trading today and it’s continuing even now is a lot of those bets went really badly wrong. And there is a type of fund which is borrowed heavily to place these bets which is really suffering now.

    Just as in previous market crashes and swings, we have seen some hedge funds and funds being knocked out by these peculiar movements. That’s what is going on right now, and that’s making the trading doubly peculiar.

  • John Yang:

    And, Diane, the stock market,the U.S. markets have been very high for a while now. Has the market — the market seemed to be looking for a bottom today. Has it found it or do you think we’re going to see selling pressure continue?

  • Diane Swonk:

    Boy, it’s hard to say because we are still dealing with this reality.

    What is kind of interesting is the reality is that now the markets really believe the Fed is going to raise the interest rates, that interest rates are going higher. We also have a lot of debt. Treasury announced last week that it was going to have to issue more debt because of the tax cuts to finance those tax cuts.

    I think all of that coming together is really important. And so it does set the stage for more volatility going forward. I agree that the volatility comments that we heard out there that Gillian pointed out are very important.

    I think what’s also really important is that we saw no one hedging their downside. As you said, many people were on the wrong side of the bets. People were like driving without a seat belt in this market, they were so confident it was only going to go up.

    And I think that is a really critical point as well. Does that mean we’re done with the correction? I don’t know. If I knew that, I would own my own island in a place that doesn’t have hurricanes, but the reality is that the economy is solid.

    We’re talking about an economy that sort of handing the baton to Main Street finally. And as we gain traction in wages, that will be very good for the economy. We do see some self-feeding momentum out there. That’s something we welcome.

  • John Yang:

    Diane, I should out that late today the White House put out a statement echoing that, saying that the fundamentals, the long-term fundamentals of the economy remain strong.

    Diane Swonk and Gillian Tett, thanks so much for joining us.

  • Gillian Tett:

    Thank you.

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