Risk Rethink

14/09/2012 at 5:16 pm

Last week it was the ECB. Yesterday – not to be outdone – it was the Federal Reserve’s turn to give markets a shot in the arm by announcing a new round of asset purchases. The Fed’s own chairman cautioned against expecting too pronounced an effect on the economy, but it didn’t matter: the numbers were large, the scope unexpected and the restatement of resolve to promote the creation of jobs most welcome.

We noted at the beginning of August that markets had seemingly rediscovered the civilized seasonal phenomenon of the “summer lull”. Through August itself that continued. This month, the change in sentiment – encouraged by the open mouth as well as the open market operations of the world’s biggest central banks – has developed into a broadly based re-rating of risk.

Equity markets have risen at a faster pace: the S&P 500 is up 4% month to date at the time or writing. And as the riskier eurozone sovereign market has continued to recover, safe haven governments have lost some of their shine. The ten year gilt price is down 3%. Credit risk has repriced significantly too: the iTraxx Crossover index of higher risk corporate credit pricing has moved from 5.9% at the end of August to 4.6% today. Commodities have bounced, with the Brent crude future up 2% and Bloomberg’s base metals index nearly 13% higher. The euro has risen 4% against the dollar and is somewhat stronger against sterling.

At the same time, economic data – some of which is significant – has continued to be mixed. While industrial production data for August was not as bad as expected in the eurozone, it disappointed in the US, where there have been mixed signals from the employment figures too. Growth in the UK has been showing some signs of recovery, while it came out slightly weaker than expected for Japan. Confidence and activity indicators around the world are similarly patchy.

It has been like this for some time now. Last year, markets were arguably too bearish about our patchy, rather chaotic recovery. If current price behaviour continues, then it might be the case before too long that sentiment could be said to have got ahead of itself.

Longer term, there are risks to consider beyond confidence too. While central banks enjoy their adulation, some may remember the “Greenspan put”. Former Fed chairman Alan Greenspan developed a reputation for cutting interest rates to prop up markets – during the stock market correction of 1998, for example, and after the dotcom / TMT collapse, when there was widespread concern over the potential “wealth effect” of falling markets on American households. Pursuit of this approach in the 2000s is now perceived to have contributed to the subprime crisis and credit crunch.

Central bank action to prop up bond markets and restore confidence in risk could end up inviting similar criticism. Much as it makes a change for markets not to be engulfed in panic and despair, it is surely no coincidence that index linked bonds issued by safe haven economies on both sides of the Atlantic have not fallen by as much as their conventional cousins.

Nonetheless, the year so far has been the first for a long time in which the volatility rollercoaster has showed signs of slowing down. The VIX index – a derivatives-based measure of volatility on the S&P 500 index – has fallen to levels not seen since the summer of 2007. Of course there could be another dip just around the corner. But while the ride has been exciting, there are many who would benefit from at least a short stop.


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