Markets had one of their most volatile weeks ever this week, with the blue-chip Dow Jones Industrial Average experiencing two different sessions where the index dropped more than 1,000 points.
The vicious drops didn't seem to worry Federal Reserve officials though. Dallas Fed President Robert Kaplan said Wednesday that the recent selloff is basically a "market event" which could be "healthy." Kaplan joined former Fed chair Janet Yellen and St. Louis Fed President James Bullard in saying that market valuations were high.
So the question is after a week where investors withdrew a record $30.6 billion from global equity funds, the S&P 500 lost more than $2 trillion from its market cap high, and all three major indices lost more than 5% of their value, when will the Federal Reserve start worrying?
Deutsche Bank Senior Economist Matthew Luzzetti has an idea.
"When does a 'healthy' correction become unhealthy and cause the Fed to scale back its rhetoric at the very least, and potentially even its expectations for rate hikes this year," Luzzetti asked in a note Friday. The answer: a 16% correction for an extended period of time.
A sustained 16% correction would have an equivalent impact on markets as an interest rate increase of 25 basis points, or approximately one Fed rate adjustment, according to the Taylor rule to which some economists adhere.
Most market analysts believe that the Fed will raise interest rates three times this year -- Deutsche Bank believes it will do so four times this year -- on the back of a strong economy.
But, confidence indicators will also play an important role in the Fed's decision-making process going forward, Luzzetti says. If the readings are healthy, they will increase the Fed's pain threshold. He expects market volatility, one of those indicators, to increase as a result.
"There is a reassessment of valuation occurring across different asset classes and it is likely you will continue to see high volatility going forward," Luzzetti told TheStreet.
Several interest rate increases have already been priced into current valuations, according to Luzzetti, and this recent selloff is more of a result of the reassessment of the bond market amid multi-year highs in the benchmark 10-year Treasury note yield.
The Federal Reserve is likely to stay the course on rates unless things get much worse, Luzzetti said.
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