Many moons ago, we lamented, “Where Has the (Perception of) Risk Gone?” Even though the markets got religion for a couple of weeks after the global downdraft of February 27, things returned surprisingly quickly to status quo ante.
Over the last week and a half, we seem to have had a mini rerun of February 27: a price shock, this time in the US Treasury bond market, and a surprisingly swift recovery. The equity markets seemed to have shrugged off the event; the fixed income markets, although a bit more skittish, seem on their way back to stability, albeit at a bit lower price level.
The Financial Times’ capital markets editor, Gillian Tett, cautions us that the picture is more complicated than it seems. What the events of last week have inaugurated, she argues, is a return of volatility. That has already brought more caution in the pricing of highly risky assets (she noted in an article on Friday that the collateralized debt market was no longer accepting rating agency ratings as the basis for pricing, recognizing their skill limitations and conflicts of interest).
If this reappraisal has started at the riskiest end of the spectrum, can it be long before we see it factored into the pricing of more mundane investments?
At the start of this week, more than 4,000 bankers congregated near the waterfront of Barcelona, Spain, for a champagne-soaked conference to discuss structured finance – or the business of creating complex financial instruments, such as derivatives.
On the surface, the mood was sunny. In the past year, structured finance has boomed, helping to create a bonanza in the City of London and Wall Street – and producing fat bonuses for many bankers.
However, as the financial whizz-kids sipped chilled bubbly under blue skies, there was an undercurrent of unease. “There are signs that the weather is changing,” observed Alexander Batcharov, an influential analyst at Merrill Lynch. “We have to take note of that.”
Quite so. For as bankers partied in Barcelona, on the other side of the Atlantic, a chill wind was suddenly blowing through the US bond market. During most of this decade, the yields on Treasuries (which represent the US government’s cost of borrowing money) have been at unusually low levels, by historical standards.
However, in recent weeks, these have started to rise – and this week, this stealthy trend turned into a rout. In the first three days yields suddenly surged 30 basis points to touch 5.33 per cent, pushing the price of US government bonds sharply lower (yields and bond prices move inversely). Although yields later closed the week at 5.18 per cent, this is noteworthy given that yields were under 4.5 per cent four months ago.
Unsurprisingly, the Treasuries swing has pushed up government bond yields in other markets, such as the eurozone. But it has not caused much obvious collateral damage in the equity market: on the contrary, share prices in many markets ended the week higher. This is striking. After all, when bond yields rise, shares prices often fall as well, since high yields tend to reflect fears of higher inflation or impending rate rises (or both).
In this case, it is true that many economists are now reassessing the outlook for rates. According to an economic measure compiled by the Cleveland Federal Reserve, for example, a month ago traders were pricing in more than a 10 per cent chance of a US rate cut in September and almost no chance of a rise; but now they give a 10 per cent chance to a rate rise – and zero probability to a cut. “The recent sharp sell-off reflects a fundamental repricing of expectations regarding Fed policy,” noted BNP Paribas on Friday.
However, one reason equity prices have remained relatively stable is that changed interest expectations were only one reason behind this week’s bond squall: technical factors, such as a decline in Asian treasury purchases, also appeared to have contributed to the swing. Moreover, the US is not facing a serious inflation scare – and credit conditions are not unusually tight, by historical standards, even after last week’s rise in yields. The important point to grasp about bond yields is that they have been so extraordinarily low in recent years that this week’s swing has merely brought them back to more “normal” levels.
But while this may be reassuring news, in one sense, there is another crucial aspect that may have more unsettling implications: volatility has blown back into the picture.
This is significant because, in recent years, bond yields have not only been unusually low but also relatively stable. That has helped to promote low volatility across many other asset classes. Indeed, the climate has been so calm that some central bankers have dubbed this decade the era of the “Great Moderation.”
Until this week, most investors apparently expected this to last for the foreseeable future. Consequently, asset managers around the world have devised numerous strategies to cope with a low-yield world – such as purchasing complex and risky instruments to get better returns. That, in turn, is one reason the bankers in Barcelona were celebrating a bumper year.
But the squall has challenged the foundations on which some of these investment strategies were based. “These movements have come as a real surprise to the market,” a senior US policymaker observed to me in New York last week. Investors, in other words, have been reminded that the era of “Great Moderation” may not always remain moderate.
That lesson was not, in itself, enough to dampen the party spirit in Barcelona. On the contrary, the investment banking industry remains so upbeat about the outlook for structured finance that the conference organisers cheerily declared they would move to the swankier location of Cannes in 2008. (Apparently this is because they need more space for the swelling ranks of bankers; but Cannes, of course, is also wonderfully handy for hosting parties on yachts.)
Nevertheless, it would be naive to expect the dust to settle too easily from this squall. For it is a fair bet that behind the scenes thousands of investors around the world are now furtively reassessing their strategies – not merely in relation to structured finance, but numerous other asset classes as well. Some of these may even be nursing significant losses from Treasuries.
That, in turn, could potentially create all manner of subtle changes in investment flows in the coming weeks. For one thing, investors may start to scale back their use of ultra-risky instruments. As Mr Batcharov says, the financial weather is indeed changing; better hang on to your investment umbrella.