VOLATILITY IS BACK

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Many ordinary Russians are standing in line at local banks trying to withdraw their savings in dollars. The value of the ruble has been cut in half since the beginning of the year, with the decline accelerating dramatically this week. Obviously weighing heavily on the Russian currency is the plummeting price of oil, now trading at roughly half its price of just six months ago. Economic sanctions imposed by western nations are also taking their toll.

When one of the world’s ten largest economies staggers, repercussions are unpredictable. Questions arise. Who holds the more than $600 billion in external debt of Russian banks and companies?

Apart from Russia, how heavily leveraged are oil companies worldwide who borrowed to expand their drilling activities to take advantage of early 2014’s rising prices? A 50% decline in oil prices, totally unexpected just six months ago, may leave some borrowers on the verge of insolvency. In turn, what lenders might be endangered?

Not surprisingly, such uncertainties make investors nervous. Over the past seven market days, the Dow has fallen 900 points from its all-time high on December 5th. Today showed quite remarkable volatility, reflecting the dichotomy between weakening fundamentals and the expectation of a year-end rally. The Dow opened down 100 points, rapidly rising about 350 points through the morning, then declining by about 360 points through the rest of the day, closing at the low.

Notwithstanding oil, Russia, the threat of contagion, as well as hideous acts of terrorism in Australia and Pakistan, investors have a deep-seated belief that late-December seasonals–especially the highly predictable Santa Claus rally–plus the positive January effect will push prices higher over the next few weeks. With most hedge funds performing far below their benchmarks for the year, there are a great many firms trying to take advantage of any rally opportunities.

That the market was unable to hold its rally on the day before a Fed announcement–an almost universally positive day over the past several years–may introduce further doubts about a prospective year-end rally. As most recently evidenced in mid-October when all world central bankers sang a dovish song to stem the September-October market decline, central bankers have adopted the support of stock prices as an additional mandate. Janet Yellen has the opportunity to provide more support tomorrow (Wednesday) both in the wording of the Fed’s statement and in her press conference to follow.

With just two weeks remaining in calendar 2014, markets may experience abnormally severe volatility as central bankers and seasonal tendencies wrestle with deteriorating world financial conditions. It promises to be a robust conflict.