As QE ends, volatility is the new normal and all asset classes may underperform: Priya Misra, TD Securities

Talking to ET Now, Priya Misra, TD Securities, says the dollar can continue to strengthen as we are pricing in more flight to quality.

Edited excerpts:

Where do we go from here in this tug of war between bonds and stocks?
It is the correlation between the two that is important. What Quantitative Easing (QE) did at start of 2009 since we had the Fed QE followed up, effectively crushing volatility and brought risk premiums much lower. Much of this repricing is essentially the end of global QE even though the Fed started tapering almost six months ago. Now that the ECB is about to start tapering, and BoJ might do it as well, it will mean the end of QE. Increased volatility is already an outcome and a new normal now. You can have a situation where all asset classes underperform. We have seen a breakdown of the normal correlation but I am not sure we should be back to that correlation where interest rates are low. You can potentially have what we are seeing now -- high interest rates, lower equities until we reach a level where you reprice the QE expectations.

Given the way how the dollar index has moved, do you think this so-called cosy trade of short dollar, long commodities, long emerging market equities could also change and lead to further disruption?
Yes, the dollar weakness was a QE trade to some extent and we started to see outperformance from the rest of the world relative to the US. That is why there has always been weakening. What we have seen now is more kneejerk quality in the dollar but I am not that convinced that Europe is entirely out of the woods. The thought is that the ECB will be able to end QE. At some point, it is possible that we are a little overdone in our optimism but that is few months out.

I am not sure it pushes back just yet and this is why the dollar can continue to strengthen as we are pricing in more flight to quality and that ultimately hurts commodities and the dollar and Yen.

There are a lot of views that this is all driven by reflation trade but if it was reflation that was driving the entire price action in the last couple of weeks, then why are equities or commodities off because reflation should be good for these. So, inflation or reflation is an easy explanation but it is not consistent with all the action. The dollar can continue to strengthen if actually this is about taking out global QE, the dollar can strengthen to the point where it starts putting enough down pressure on inflation in the US but then it actually slows the Fed down. There will be a breaking point but I am not sure we are there yet.

So what is that we are staring at because Bridgewater Associates’ Bob Prince believes that the world markets were getting extremely complacent and there is a bigger shakeout coming? He says “what we have seen in the last fortnight is not it. Brace yourselves, there is going to be further weakness in the market.’’ Would you say that what we saw in the last fortnight was a flavour of what is to come and may be oil markets would once again realign to the new norms, with the way the dollar as well as the index have been panning out and what is happening in commodity markets separately?
I am somewhat sympathetic to the Bridgewater view because we have seen global central banks starting to normalise but actually long-term economic growth fundamentals show that it is much higher. The US demographics or productivity have not particularly picked up. The question always was how much can the Fed hike or how much can they let the portfolio run off and we are sort of figuring out what that level is, it is clearly not here. So, interest rates can rise. There is no sign so far that this rate rise is having any impact on the economy. In fact, New York Fed President Dudley called it “small potatoes. ” I do not see that if interest rates continue to rise, as we are priced out from accommodative stand of global central banks, I all other asset class have to react. So, higher and lower equities, strong dollar, weaker EM and then at some point it will have to align itself to fundamentals when we realise that high interest rates began to hurt the US housing market. I think we are in a period of turbulence and we need to go back to fundamentals and say interest rates should not be higher than a certain level.