Given the volatility in the markets, if your head is spinning, you have my sympathy.

The intraday volatility over the last 10 days in the S&P 500 Index has been high. The Volatility Index, which is an implied measure of daily stock market volatility, is not up that much but realized volatility surely feels like it is much higher.

Just look at the 10-day intraday volatility in the S&P 500 (Exhibit 1).

Much Weaker Dollar Needed Before Markets Reach Low - OppenheimerFunds

The question then is: Given the extent of the correction and the perceived volatility in equity markets, how would we know if the turbulence is over or just reached a near-term low?

Waiting for China

From a fundamental standpoint, my guess is that if we somehow could assert that China is nearing the end of the adjustment period in its economy, it would definitely be a cathartic moment for the global capital markets. Since that marker is, at best, at least a few years away and, at worst, a decade or two away, I suppose waiting for it would be like waiting for Godot, in other words, waiting for something that will never arrive.

Furthermore, the global debt and deflationary overhang makes it unlikely that the bottom in asset prices driven by any fundamental improvement in the global growth picture is coming anytime soon.

Fed Policies Matters Most

So if the fundamentals are unlikely to get us there, it has to be central bank liquidity. Raising asset prices through increased liquidity is a tried and true central bank strategy, especially in periods of debt and deflationary overhang.

In that context, the central bank that matters most is the U.S. Federal Reserve (Fed). The European Central Bank and Bank of Japan can help, but given the fact that economic trend growth in the U.S. is likely to be meaningfully higher on a sustained basis than in Europe or Japan, it is the Fed that must keep the U.S. economy out of the deflationary dragnet through a monetary policy. If such a policy is not forthcoming, in my view, financial markets stability is not forthcoming, either.

Unfortunately, the Fed has badly muddled its monetary policy message over the last 18 months. Fed policymakers have gotten the worst of all outcomes: they have not been able to get off of the zero lower bound but, due to policy missteps, have been able to crush the animal spirit and thus the growth potential of the U.S. economy. So it seems to me that if we are going to get stability in the markets, the Fed has to back off – and back off on a permanent basis, or at least until the global deflationary readjustment is well underway.

But the Fed is unlikely to step up and tell us that it is going to back off. Instead, the markets will start discounting that proposition and, clearly, the markets have started thinking and pricing their thinking along those lines. However, looking to the rates market, which reflects the market’s combined expectations on future interest rate moves, being able to tell whether the Fed is backing off on a permanent basis is going to be almost impossible.

Dollar Correction Not Enough

So, what am I watching to make sure that something along those lines is getting priced in? Simple answer: the dollar. A significant correction in the dollar means the Federales are retreating.

Guess what? The dollar has had one of the biggest sell-offs in a year over the last few days (Exhibit 2).

Much Weaker Dollar Needed Before Markets Reach Low - OppenheimerFunds

Does it mean we are getting close to a bottom? I am certainly encouraged by the price action of the dollar. However, when I look at the longer term picture of the dollar, I get somewhat discouraged (Exhibit 3).

Much Weaker Dollar Needed Before Markets Reach Low - OppenheimerFunds

In my mind, a further significant weakening of the dollar is a necessary condition, but not sufficient all on its own for the markets to reach their low and begin their turnaround. How much more does the dollar have to weaken for that to happen? Probably close to its 2014 levels.

However, the January employment report may make it less likely the dollar will weaken to that level any time soon. While the U.S. economy created a slightly less-than-forecast 151,000 jobs last month and the Labor Department revised December’s jobs number downward, all the other aspects of the report were quite strong: Positive growth in manufacturing, meaningful wage growth, and a drop in the unemployment rate to 4.9%, the lowest since February 2008.

In sum, the January labor report indicates that additional rate hikes may still be on the table, as strong employment and wage growth may be a sign the U.S. economy is moving closer to reaching the Fed’s inflation target. Fed policymakers may skip another tightening in March, as Vice Chair William Dudley has indicated, but the Fed remains very much in play. That means a stronger dollar and, as a result, continued stress in the financial markets.

Until the markets think the Fed has gotten off the tightening path permanently, I don’t think we will reach a low.

Follow @krishnamemani for more news and commentary.