The US equity markets sailed with equanimity into last week’s Thanksgiving break. A strong rally has seen the Dow Jones Industrial Average index gain about 15 per cent since midyear, bringing with it similar rises in the developed and emerging worlds and a rash of acquisitions.
But the data used by market professionals to show the level of anxiety in the market are perplexing. On the face of it, despite great uncertainty over the direction of the US economy, nobody is worried about anything.
The Chicago Board Options Exchange’s Vix index, one popular measure of volatility, infers levels of anxiety from what investors are prepared to pay through the options market to hedge against future volatility in share prices. The Vix hit an all-time low last week. Volatility in the foreign exchange and credit markets is similarly at very low levels.
There is also little sign of risk being priced into securities. The extra yields, or “spreads”, that investors receive for buying relatively risky paper such as emerging market debt, “junk” corporate bonds or the stocks of smaller companies, are all at or near historically low levels. This is out of kilter with the US Treasury bond market, arguably the most sensitive to the economy. It is signalling a sharp slowdown next year.
Normally, investors require a higher yield on longer-term bonds. This is logical, as there is greater uncertainty further into the future. When long-term yields are lower than short-term yields (known as an inverted yield curve), it implies that the market expects an imminent worsening of conditions and lower interest rates.
The yield curve for US Treasury bonds has been inverted for a while – and the inversion has deepened over the past month as stocks have continued to rally. Ten-year Treasuries last week yielded 18 basis points less than two-year Treasuries – a strong signal that the market expects a recession.
Moreover, the Treasuries market has seen sharp swings in recent months. That reflects uncertainty over the direction of the economy. The Federal Reserve, America’s central bank, has been “on hold” since midsummer, leaving the baseline Fed funds rate at 5.25 per cent after two years of tightening.
Economists differ widely on the outlook. One view is that the so-called “Goldilocks” scenario – in which the economy will be not too hot and not too cold – will win out. The economy will slow down, and with it inflation, allowing the Fed to start cutting rates next year, but without subjecting the country to a full-blown recession. Such an outcome would justify the rally in stocks and the low levels of volatility.
But many argue that the Fed will have to raise rates next year, as signs of buoyant growth remain, notably in employment data. Others contend that the Fed will have to cut rapidly in the face of a “hard landing” for the economy, triggered by the sharp falls that are under way in US housing prices. The Treasury bond market seems to be discounting a substantial risk of a hard landing. That makes movements in many other markets harder to explain.
In the credit market, the Dow Jones US CDX indices, which measure the spread investors pay for investment-grade debt in the credit derivatives market, have dropped sharply in recent weeks, to historical lows. A similar trend can be seen in high-yield bonds, where default is always more likely. But the credit derivatives market exists to protect investors against default risk – it makes it much easier to gain exposure to the bonds of a number of different companies, limiting exposure to a default by any single company. When the economy heads for recession, as the Treasury market believes, then default risk should rise. How, then, can the credit market behave as though the default risk is falling?
In the foreign exchange markets there are similar causes for concern, which the 2 per cent fall in the dollar amid quiet Thanksgiving trading at the end of last week exacerbated. For example, some leaders of the Group of Seven industrial nations are grumbling that both the Chinese renmimbi and the Japanese yen are undervalued.
There are easily conceivable events that could cause both currencies to move up sharply. The Bank of Japan could decide to lift base rates significantly from the current level of 0.25 per cent, or the Chinese authorities could decide to diversify their foreign currency reserves, currently held predominantly in dollars – an event that could hit the US unit and raise bond yields. Add to this the deep uncertainty over the next move from the Fed and there should be much uncertainty in the foreign exchange markets.
And yet HSBC reports that the European Central Bank’s “global hazard indicator”, which measures the implied volatility of currency trading, had fallen to an all-time low before the activity around Thanksgiving. HSBC’s own take on the data is simple enough: “It means, in effect, that the markets do not give a fig for cyclical risk.”
Chris Watling of Longview Economics, a consultancy, suggests the complacency towards risk is a global phenomenon. Looking at more than 150 global financial assets, he finds an average short-term volatility of about 13 per cent – historically low, and less than half its level of May when world markets suffered a brief but dramatic swoon. Indices from the German Dax 30 to South Korea’s Kospi are experiencing their lowest volatility ever.
Various technical explanations might explain low volatility in different markets. For example, there are persistent claims that central banks are intervening to maintain stability in foreign exchange, while a profusion of complex credit instruments makes it easier to manage risk in the credit markets.
The apparent recession indicator in the bond market might also be explained away by technical factors. Demand for long-dated bonds may be high thanks to pension funds’ need to match their liabilities as the “baby boom” generation’s retirement starts, or thanks to demand for US assets from the Chinese authorities.
But Bankim Chadha and Jens Nystedt, foreign exchange strategists at Deutsche Bank, suggest that if low volatility is such a universal phenomenon, there may be a common cause. They also dismiss the suggestion that it has to do with any secular shift, pointing out that volatilities across all asset classes have not displayed any trend, or shift in the average level, over the last 30 years. This is what would be expected with structural change. Therefore, they say that “the recent decline in volatility is cyclical and not driven by structural drivers”.
They add that it is hard to argue that geopolitical risks are declining or that general macroeconomic risks have reduced. They suggest that the current low volatility is caused by the stage in the economic cycle and by factors the financial markets have generated for themselves. This in turn implies a much bumpier ride ahead. They say: “Looking at history, higher interest rates affect financial leverage with a lag and once interest rates start to bite (usually with a two-year lag) financial volatilities return to normal.” They predict that S&P volatility could double next year, even if there is a “soft landing” in the economy.
Credit and foreign exchange markets, both of which have seen heavy involvement by hedge funds, arouse the most worry. “Bears” fear that equities are being propelled by cash that has been generated only by the unusual conditions in these markets and which could therefore soon be taken away.
In foreign exchange, the concern is that investors are indulging in the “carry trade” – borrowing money in a low-yielding currency, such as the yen, and parking it in a high-yielding currency like the Australian or New Zealand dollar or the Swiss franc. This generates easy money that can then be poured into other markets.
The great risk is a sudden appreciation in the yen – as happened last week, when the dollar moved from Y118 to Y115.7 in three days. Any such sharp volatility could swiftly turn this strategy into a money-loser, although it was not clear by the weekend whether carry trades were unwinding. Analysts diverge on the extent of speculative carry trades but the Bank of Japan has made clear it is worried about the possible impact of a sudden unwinding – and that it expects to raise rates further. That would be likely to boost the yen and damage the carry trade.
From the credit market, the fear is that spreads have been driven to such low levels that speculators have no choice but to dive for the equity market. Alan Ruskin of RBS Greenwich Capital says: “Many traders feel that the easier risk-asset trade is directly in equities, given a belief that valuations are less extended than in the credit market or emerging currencies.”
Further, there are worries about the role of credit derivatives. In making it easier to diversify default risks, these make it far less likely that one big default could bring down a few institutions that were the casualty’s biggest creditors. They thus do allow banks to take on greater risks elsewhere.
However, they cannot diminish the risk of default across the economy. Yet they are currently priced as though credit default risks are falling, which runs contrary to the signals emanating from the Treasury bond market. Tim Lee, of Pi Economics in Connecticut, and a self-confessed “bear”, suggests this is reason to be pessimistic. “Banks can just keep lending and then seeming to lay off the risks through credit default swaps – it seems never-ending.”
With such concerns, many find themselves hoping for increased volatility. But that could soon turn into excessive volatility, particularly if the US economy does move into a hard landing or if carry trades unwind in a hurry. According to Mr Chadha and Mr Nystedt of Deutsche: “We expect in 2007 that the traders’ and clients’ concerns about volatilities could surprisingly quickly be replaced with concerns about too high volatility.”