Pausing For Breath

15/02/2013 at 6:21 pm

We are only 46 days into 2013, but it feels as though markets have covered a lot of ground already. The FTSE 100 index is up 7.5% so far, which would make a decent positive return for a full year. So it is something of a relief that risk assets have had their exuberance contained in the last week or two by weaker than expected Q4 growth numbers from the major developed economies (the US at the end of last month, Japan on Wednesday and the eurozone a day ago).

With all the excitement we have been enjoying in equity markets, however, it has been easy to overlook the more mundane – and in some cases, divergent – pricing behaviour of other assets.

Oil, for example, is only $4-$5 a barrel higher, and remains well below the levels reached in early 2012. The story is similar for industrial metals.

Precious metals have been more enigmatic. Silver had a strong January but has since fallen to where it ended last year. Gold shrugged off the euphoria last month to begin the year flat, before dropping just shy of 3% in dollar terms in what we have seen of February so far. Both metals remain on the downward trajectories established for them since risk assets began to recover a few months ago, but the shorter term dislocations and contradictions are as mystifying as ever.

More mystifying still has been the behaviour of credit. Safe haven government bond markets have been acting as one might expect: 10 year yields in the US, Germany and the UK are 25-35bp higher on the year so far. But investment grade credit spreads, as measured by the Markit iTraxx Europe index, are barely narrower from December’s close. At the same time, the rally in emerging market debt has stalled, with the JP Morgan EMBI Global spread a few bp wider.

Currency markets, more reassuringly, are aping equities in that they have also paused for breath this month after following a consistent pattern. The euro rallied strongly, and has now faltered. The yen continued its sharp decline – which has slowed. The world’s new-found and startling allergy to sterling has stabilised. All this could tie rationally in with improving sentiment over the world economy (now paused) and the abandonment of safe havens (ditto).

The economic outlook, as always, is uncertain. Those GDP numbers we’ve seen of late have not been encouraging. But other data has been positive: on American jobs, Chinese activity, European (and UK) sentiment … So far, despite the hiatus, and the short term dislocation in risk pricing between some asset classes, markets are giving the world the benefit of the doubt.

This blog is inclined to agree with them. There is one market we have been following for some time: the peripheral European bond market. Back in November ’11, when panic was the only thing some wanted to buy and Italian 10 year paper was hovering around 7-7.5%, we observed:

It was hugely significant during the recent [Aug 11] crash that Italy’s bond yields did not rise to dangerous levels. If they continue to hold their ground – or better yet, if confidence improves and they fall – catastrophic contagion in the eurozone is unlikely to occur. Talk about the banks, and haircuts, and credit derivatives is all very interesting. But if you really want to know how afraid to feel, just keep an eye on those bonds.

Year to date, spreads on Spanish, Italian, Greek and Portuguese debt to Germany have continued to narrow. This measure has survived the stall in equity pricing. In terms of absolute yield, Portuguese 10-year debt has fallen from almost 14% to a little over 6% in under a year.

Bond markets have decided that fear is not going to win this winter. As ever, their view is subject to the verdict of time. And as ever, the inconsistencies and dislocations we have seen emerging during the excitement of 2013 so far will be resolved – one way or another.


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