The desperate rush to avoid risk

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The apparent urge to reduce risk which has been so apparent over recent weeks shows absolutely no sign of ending any time soon, judging by market developments over recent days. Friday’s truly terrible US payrolls figures, Europe’s slow-motion sovereign debt train crash, and a growing sense of inevitability that most of the world’s largest economies will soon be back in recession have further perpetuated this intolerance for risk, which in turn has provided safe haven currencies like the Swiss franc, Japanese yen and US dollar with some further impetus, and given safe haven assets like gold and bonds another lift. Both gold and bonds are in unchartered waters, the former reaching a new record high of $1,921 overnight.

Similarly, in the three major bond markets, yields have never been this low. US 10yr treasury and German 10yr Bund yields are well below 2.0% and 10yr Gilt yields are now at just 2.29%. These gains in bonds are not simply a risk reduction reflex – there is a genuine probability that major central banks such as the Fed and the BOE will soon need to implement measures to prevent their economies from sliding back into recession, such as quantitative easing or twist operations (which would require further purchases of long term securities). In contrast, the mood in equity markets continues to darken. For the quarter-to-date, the UK market is down by 14%, while across the pond the S&P 500 has lost 11% (it was closed yesterday on a day of heavy losses).

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Interestingly, the German DAX has been absolutely savaged since the middle of the year, down 29%! Some of the other European bourses are not far behind Germany – the French CAC-40 has dropped 25% over the same period, while Italy’s MIB index has lost 29%. In forex markets, the usual suspects are excelling, at the expense of high-beta currencies. Both Tokyo and Berne will not be best pleased by the renewed strength of their currencies over recent days. High-beta currencies have fallen back, but not by nearly as much as might have been expected given the sharp decline in equities and apparent concern that global growth is under threat. For instance, the Aussie is now near 1.05, having reached a multi-decade high of 1.11 not that long ago. As such, it could be argued that the turmoil in financial markets over recent weeks has been much more about bond/equity risk re-rating in an environment of reduced confidence in long term economic growth.  .

Commentary

Italy left badly exposed by fiscal backtrack. As expected, Italian bond yields continued to soar on the first day of the new week in response to last week’s fiscal hesitation by the increasingly beleaguered Berlusconi government. Despite further talk that the ECB had stepped in to buy more BTPs, the 10yr Italian bond yield was up 30bp at one stage at 5.53%, the 12th consecutive day of losses; just two weeks ago, yields were 70bp lower. Even more disturbing was the dramatic widening in spreads – the 10yr GER/IT bond spread was out by 45bp to more than 365bp! Berlusconi’s decision last week to fundamentally alter his fiscal austerity package has deeply disturbed not just owners of Italian government paper, but also members of the ECB policy-making council who agreed to extend their SMP to Italy on the understanding that they would undertake meaningful fiscal reforms. With Europe’s sovereign debt contagion having sucked in Italy once more, amidst question-marks over their long term ability to fund their debts at these elevated interest rates, the threat to the euro has understandably moved into an even more serious phase. As such, it is not surprising that the single currency has backed right away from the 1.45 level over the past week.    

Stall speed in the UK. The latest services PMI data, when combined with the manufacturing data, suggest that the UK economy is somewhere near stall speed. The fall to 51.1 on the services measure last month takes it below the 12-month average (at 53.5) and does not bode well for the Q3 GDP numbers, especially when combined with the sub-50 reading on the manufacturing series.  The ONS made out that the weakness seen in Q2 (gain of 0.2% QoQ) was down to some one-off factors that would lead to some bounce-back in the third quarter. However, yesterday’s data make this prospect look ever more unlikely, not least because some of the ONS’s rationale for expecting a bounce-back looked weak at best. The PMI survey showed service sector business expectations at their lowest level for a year, dampened by government spending cuts and general economic certainty.
We know from the minutes of the last MPC meeting that the possibility of QE received a little more discussion than was anticipated.  This will keep the market slightly on edge later this week when the latest interest rate decision is announced.  It seems unlikely that the Bank will shift to more QE at this stage, but if the subsequent release of the minutes showed the verbal momentum building, it could well become the default setting for markets going into the next meeting.  Watch this space.

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