Markets seem to have overcome the volatility experienced earlier in the year, as some key risk factors appear to have been “resolved”. There are the always-present concerns about the global business cycle and its components, and these days the US and Chinese cycles are as important as ever. But the more recent volatility seems to respond to fears of the new related to two risk factors: Greece exiting the euro and the US monetary policy normalization.

Both Greece and US monetary policy present markets with unprecedented scenarios, which have had no similar phenomena, studied neither empirically nor theoretically. I believe the probability that Greece exits the euro during this year has increased significantly in the last month. At the same time, it is now fairly consensus that the first post crisis interest rate hike by the Fed will happen this year, and we will learn more about this tomorrow from the Fed. That interest rate hike marks the beginning of monetary policy normalization, from a point never witnessed before, as measured by the size of the Fed’s balance sheet vis-à-vis the size of the economy. Thus, the fact that these are unprecedented events likely to happen is not controversial. The debate starts when one tries to assess the impact these events would have on fundamentals and markets, how widespread, how durable.

The new Greek government won the elections by pledging to end austerity and suspend most of the reforms demanded by the ‘institutions’ (which stands for the troika of the IMF, the ECB and the EU). Last month, in order to get an extension of the program the government had to show serious flexibility on its claims, but no real agreement was reached and financing is still dependent on progress based on the old program. Given the risk, bank deposit outflows and falling tax revenues put the Greek government in a very difficult position, needing the external funding to avoid default and collapse. On the other side, the ‘institutions’ have an incompatible set of incentives. If they compromise and show serious flexibility towards the Greek demands, then other populist political parties within the euro area will feel emboldened. The key subject here is ‘Podemos’ in Spain, with elections in November. If Podemos wins and demands a renegotiation à la Syryza, then Spain is at risk of exiting the euro. The moral hazard problem is clear, and the solution is not very hard to compute: unless Greece complies with the institutions’ reform agenda in exchange for financing, it is better to see Greece leave than to risk the same phenomenon happening in Spain. And after Spain come not only Portugal and Italy, but also France; with presidential elections in 2017 in which Marine Le Pen could produce the final blow to the EU project. Thus, Greece is a small cost to pay to stabilize the incentive problem. It all depends on whether the Greek government understands and shows enough flexibility. If so, there would be some flexibility on the German side. But the risk of a country exiting the euro is real, and new.

US monetary policy has been an experiment of unprecedented magnitude. The Fed’s balance sheet is almost 4 times the size it was before the 2008 crisis. Normalization does not mean a quick return to the past, which would most likely not happen for a very long time. But it does mean to move in that direction, though slowly. Why is this important? Well, it is important mostly for one reason: it is not easy to answer the question of how much of equity markets performance over the last few years has been the result of monetary policy and how much the correct pricing of fundamentals. We tend to believe that monetary policy normalization is needed and should be good fundamentally. However, markets have not seen such a process in the works. Markets have experienced rate hikes, monetary policy tightening, but never from the current levels of rates and size of central bank balance sheet. An added complication, or maybe moderation, is the divergent nature of G4 monetary policies. While the Fed and the Bank of England seem headed for normalization, the Europe and Japan are clearly headed for expansion of its monetary stimulus.

None of the above is clearly a shock to fundamental factors like productivity growth, etc., but markets can produce serious volatility around an improving trend, and this is bound to be the case over the next year or so.