The past week in the market has been a wild ride, with the S&P 500 index dropping more than 10% YTD intraday on Monday and the VIX (a measure of stock market volatility) crossed over 30, a level associated with potential extreme swings in the prices. So, what is driving the recent spike in volatility? In our opinion, we can boil down the cause to two main issues each with their own underlying concerns.
First, the Federal Reserve (Fed) is expected to raise interest rates 3 or 4 times in 2022 in order to combat inflation. By raising rates, the Fed directly affects short-term interest rates via the Fed funds rate and in doing so indirectly affects the discount rate applied to equity valuation models. As the discount rate increases, in general, the price of equities declines. An issue arises if the Fed decides to change course similar to what happened in Q4 2018. Should the Fed abort their interest rate raises for one reason or another, the stock market could possibly bounce back quickly.
Second, geopolitics could be causing some investors to reduce exposure to risk assets. Should events escalate, we could see a situation where oil spikes, supply chains are further impacted, and ultimately drive further inflation. The stock market tries to discount all possible risks and as such may be contributing to the recent volatility.