“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness; […] it was the spring of hope, it was the winter of despair.”
Dickens’ famous opening words in The Tale of Two Cities could set the scene for the current market and macroeconomic climate – a world of latent volatility; where contradictory extremes loom as equally likely realities; where the slightest change in political winds could send events either way.
Is it to be a time of inflation or disinflation, liquidity or illiquidity, growth or slump?
The dramatic return of share-price volatility in the first quarter of the year indicates some plot issues that may be resolved in 2018, but others remain hidden in the subtext. In the latest Hermes Market Risk Insights report, Spring of hope, or winter of despair? Investors face Dickensian conditions, Eoin Murray,Head of Investment at Hermes Investment Management, explores the six key risks facing investors in extreme financial conditions.
Volatility: Hard times ahead?
The piece highlights volatility’s return and how it remains the ‘thematic touchstone’ for risk in financial markets. Murray explains: “With the exception of the observed spike in equity volatility, across the board, long-term implied volatility measures continued to drop for all asset classes over the quarter. But we expect other asset classes will follow the share market lead into more volatile territory.
“Overall, our view is that volatility will return to more normal historical levels across asset classes. We reiterate our long-held concern that the current low implied volatility environment encourages investors to dial-up their market exposures, often through leveraging.”
Correlation: Greater expectations
Moreover, cross-asset global correlation has remained stubbornly in a band from 2007, with assets largely moving together – with the measure sticking below levels not often seen since before the financial crisis. Murray says: “We continue to keep a close eye on this critical signal. From time-to-time, the correlation surprise metric will give false-positive signals, but we remain cautious about any portfolio assumptions with respect to cross-asset relationships.
“Despite the wider array of asset classes offering potentially greater sources of diversification, investors are increasingly herding around common risk and portfolio management strategies. We anticipate regime change in correlation this year. In a changed investment environment investors will need to adapt by combining different portfolio construction and risk management methods”
Stretch risk: The plot thickens
Volatility is the marquee measure of risk in financial markets; but asset price stability itself can mask underlying dangers. Take, for example, fully-priced assets that may exhibit low volatility – but hide substantial downside potential. The report uses ‘stretch risk’ analysis to zero in on these apparently low-volatile assets and/or those that have trended in one direction or another for an extended period.
Overall, there are examples of stretch risk in both equity and bond markets, either from a momentum or extreme valuation perspective. “The injection of liquidity from UMP – now drying up – has led to an unstable floor for downside risk, which and we see this continuing to develop in unpredictable ways throughout the remainder of this year,” Murray states.
Liquidity: Bleak times ahead?
The report underlines further rotation in fund managers’ most crowded trades. As fast as ‘Long Bitcoin’ appeared, it is now dropping off the radar to be replaced by ‘Long Big Tech’ and Nasdaq stocks more generally.
Murray says: “Even before the latest rise, tech stocks were already a popular trade with investors also showing a persistent appetite to go long the corporate bond markets. Short volatility, unsurprisingly, took a bullet, but as volatility fell back, investors may have been tempted to reload. We believe concerns over liquidity risk in the corporate debt market remain highly relevant.”
Event risk: Further twists ahead
The report’s Turbulence Index rose to its highest level for nearly eight years during February’s sell-off. Murray explains: “The uptick in the Turbulence Index implies that markets were behaving less normally relative to their own recent past – driven by the return of normal volatility levels. We anticipate that the measure will experience further spikes during 2018.”
Meanwhile, the report’s Policy Uncertainty Indicator has remained at the lower end with investors discounting politics as less influential than economics. It would foolish to ignore possible knock-on effects from simmering trade war tensions between the US and China, real conflict in the Middle East and renewed uncertainty in Europe.
ESG Risk: Tale of two commodities
In terms of ESG risk, the report tackles hard questions of water and concrete. As communities around the world face a growing water crisis, the need for lower-cost means to secure ample and clean water is growing in importance. For example, half of India’s water supply in rural areas is routinely contaminated with toxic bacteria and each year about 600,000 Indian children die from drinking unclean water.
Murray says: “Natural infrastructure approaches have a major role to play in confronting the impending crisis. Solving the problem requires interaction from a number of stakeholders (utilities, business, government and communities) – an approach that, unfortunately, does not prevail in all countries.”
France announces loan plan to spur post-COVID business investment
By Leigh Thomas
PARIS (Reuters) – The French government on Thursday launched a new programme to relieve small and mid-sized firms’ strained balance sheets with quasi-equity debt partially guaranteed by the state.
After months of tough negotiations between the finance ministry and EU state aid regulators, firms will be able to tap up to 20 billion euros ($24 billion) in loans and subordinate bonds from early next month, Finance Minister Bruno Le Maire said.
“This will be an unprecedented raising of capital for investment in Europe and it should be a model for other European countries,” he said during a presentation of the programme.
French firms went into the COVID-19 crisis last year already with a record level of debt, and they took out an additional 130 billion euros in state-guaranteed loans from their banks as cashflow collapsed during France’s worst post-war recession.
Under the new programme, the debt will be junior to all claims other than a firm’s equity, it will have a longer maturity of eight years and must be used specifically for investment rather than refinancing existing debt.
The new debt is also more flexible, with a four-year grace period on principal repayments, but will also carry higher interest rates of 4-5.5% to cover the greater risk.
The scheme is innovative as banks will extend the loans to firms and then sell them on to institutional investors such as insurers through private investment vehicles, whose potential losses will be covered up to 30% by the state.
HELPING SMALLER FIRMS
While bigger companies have long had access to the high-yield debt markets, smaller firms in Europe have until now had to rely on shorter-term financing largely from banks, unlike in the United States where more flexible options have long existed.
France has in the past struggled to get a market off the ground for small-firm financing and hopes are high that this time the state guarantee will give an extra boost.
European firms’ heavy debt burden has fuelled concerns among economists and policymakers that they will not have the financial strength to carry out the investments needed for a strong recovery from the coronavirus crisis.
EU competition enforcers cleared the scheme on Thursday after lengthy negotiations to get the right risk-reward balance while not giving French firms an unfair advantage over their European rivals.
The onus will fall on banks to ensure through their client relationships that the loans are extended to firms strong enough to make good use of the funds.
“By taking 10% of the loans on our balance sheets without a state guarantee, that implicates us in the quality of these instruments,” said Credit Agricole Chief Executive Philippe Brassac, who also heads the French banking federation.
The state had originally planned to offer a guarantee of only 20% but had to increase that to 30% to attract institutional investors into the new market.
($1 = 0.8294 euros)
(Reporting by Leigh Thomas; additional reporting by Foo Yun Chee in Brussels, Editing by Gareth Jones)
Bond scares linger, investors look to Powell
By Tom Arnold and Hideyuki Sano
LONDON (Reuters) – Worries about lofty U.S. bond yields hit global shares on Thursday as investors waited to see if Federal Reserve Chair Jerome Powell would address concerns about a rapid rise in long-term borrowing costs.
The spectre of higher U.S. bond yields also undermined low-yielding, safe-haven assets, such as the yen, the Swiss franc and gold.
Benchmark 10-year U.S. Treasuries slipped to 1.453%. They earlier touched their highest levels since a one-year high of 1.614% set last week on bets on a strong economic recovery aided by government stimulus and progress in vaccination programmes.
“Equities and yields continue to both drive and thwart one another,” said James Athey, investment director at Aberdeen Standard Investments.
“Fed speech continues to express very little concern and certainly is not suggestive of any imminent action to curb the rise in yields. The Powell speech today is hotly anticipated, but I fear more out of hope than rational expectation.”
The Euro STOXX 600 was down 0.5% and London’s FTSE 0.6% lower.
The MSCI world equity index, which tracks shares in 49 countries, lost 0.5%, its third day running of losses.
The MSCI’s ex-Japan Asian-Pacific shares lost 1.8%, while Japan’s Nikkei fell 2.1% to its lowest since Feb. 5.
E-mini S&P futures slipped 0.2%. Futures for the Nasdaq, the leader of the post-pandemic rally, fell 0.1%, earlier hitting a two-month low.
Tech shares are vulnerable because their lofty valuation has been supported by expectations of a prolonged period of low interest rates.
But the market is focused on Powell, who is due to speak at a Wall Street Journal conference at 12:05 p.m. EST (1705 GMT), in what will be his last outing before the Fed’s policy-making committee convenes March 16-17.
Many Fed officials have downplayed the rise in Treasury yields in recent days, although Fed Governor Lael Brainard on Tuesday acknowledged that concerns over the possibility a rapid rise in yields could dampen economic activity.
In addition, anxiety is building over a pending regulatory change in a rule called the supplementary leverage ratio, or SLR, which could make it more costly for banks to hold bonds.
“The market is likely to be unstable until this regulation issue will be sorted out,” said Masahiko Loo, portfolio manager at AllianceBernstein. “There aren’t people who want to catch a falling knife when market volatility is so high.”
The market will also have to grapple with a huge increase in debt sales after rounds of stimulus to deal with a recession triggered by the pandemic.
The issue is not limited to the United States, with the 10-year UK Gilts yield on Wednesday touching 0.796%, near last week’s 11-month high of 0.836%, after the government unveiled much higher borrowing.
On Thursday, Germany’s 10-year yield was down 2 basis points to -0.31% after rising 5 basis points on Wednesday, still moving in tandem with U.S. Treasuries.
Currency investors continued to snap up dollars as they bet on the U.S. economy outperforming its peers in the developed world in coming months. [FRX/] The dollar rose to a roughly seven-month high of 107.33 yen.
“U.S. dollar/yen has been on a one-way trajectory since the start of 2021,” said Joseph Capurso, head of international economics at the Commonwealth Bank of Australia. “The brightening outlook for the world economy is a positive for both U.S. dollar/yen and Australian dollar/yen.”
Other safe-haven currencies were weakened, with the Swiss franc dropping to a five-month low against the dollar and a 20-month trough versus the euro.
Other major currencies were little changed, with the euro flat at $1.2054.
Gold fell to a near nine-month low of $1,702.8 per ounce on Wednesday and last stood at $1,714.
Investor focus on a U.S. economic rebound was unshaken by data released overnight that showed the U.S. labour market struggling in February, when private payrolls rose less than expected.
Oil prices rose for a second straight session on Thursday, as the possibility that OPEC+ producers might decide against increasing output at a key meeting later in the day underpinned a drop in U.S. fuel inventories. [O/R]
U.S. crude rose 0.6% to $61.65 per barrel. Brent crude futures added 0.7% to $64.54 a barrel,
(Additional reporting by Koh Gui Qing in New York; editing by Sam Holmes, Richard Pullin, Simon Cameron-Moore, Larry King)
Analysis: Global bond rout puts BOJ’s yield curve control in spotlight
By Leika Kihara
TOKYO (Reuters) – The Bank of Japan’s success in controlling the shape of the bond market’s yield curve could tempt other central banks to consider deploying similar tactics as they grapple with a rise in borrowing costs that could cripple their economies.
The Japanese central bank has kept bond yields largely pinned inside a narrow range around 0%, since it adopted its yield curve control (YCC) policy in 2016.
The merits of the policy are clear. By shifting to targeting yields, the BOJ could buy fewer bonds than under its massive bond-buying programme many analysts saw as unsustainable.
With a pledge to cap the 10-year Japanese government bond (JGB) yield at zero, the BOJ has kept rises in the benchmark yield at just 17 basis points this year, even as the U.S. Treasury yield spiked 70 points.
“YCC is working quite well. It relieved the BOJ from the burden of having to buy bonds at a set pace,” said former BOJ executive Shigenori Shiratsuka, currently professor at Keio University.
“Major central banks will probably follow in the footsteps of the BOJ,” as keeping rates low would be crucial in helping governments manage the huge cost of combating COVID-19, he said.
Indeed, some central banks are warming to YCC as they hunt for ways to reflate growth with dwindling policy ammunition.
Australia’s central bank adopted YCC in 2020 and defended its three-year yield target with huge bond buying.
The European Central Bank does not conduct explicit YCC but is tying its stimulus more heavily to the yield curve.
ECB board member Fabio Panetta said on Tuesday the recent steepening in the yield curve was “unwelcome and must be resisted,” pointing to the merits of a “firm commitment to steering the euro area yield curve.”
“This has to be as far as any ECB official ever went in terms of YCC commitment,” Pictet Wealth Management strategist Frederik Ducrozet said of Panetta’s comments.
NOT FOR EVERYONE
Japan’s nearly five years of experience with YCC has exposed some of its flaws. The BOJ has said it will look into making its tools more “sustainable and effective”, including by addressing the demerits, when it carries out a policy review this month.
Indeed, YCC could be difficult to maintain and may not suit everyone. The Fed has stopped short of introducing a yield cap, despite studying it for years.
BOJ policymakers concede YCC worked in Japan because of the central bank’s huge presence in the bond market and a dearth of expectations that inflation would pick up.
On the rare occasion the 10-year yield deviated from its target, the BOJ stepped up purchases such as through a “special” operation where it offered to buy unlimited amounts at a set price.
This could be a costly operation in a vastly diverse $18 trillion U.S. Treasury market, where controlling yields could be far more challenging than in the $9 trillion JGB market.
“I won’t rule out the chance of the Fed adopting a two-year yield cap, if interest rates continue to rise and destabilise the stock market,” said former BOJ official Nobuyasu Atago, who is now chief economist at Japan’s Ichiyoshi Securities. “But there’s a lot of uncertainty on whether it will work.”
For now, major central banks see no problem with higher inflation. Fed policymakers consider the recent jump in yields as an “appropriate” reaction to hopes for higher growth.
Even if the rise were to be considered too much, the Fed has an interim step short of YCC, such as buying longer-dated bonds.
Being too successful with YCC comes at a cost. Market liquidity dried up as Japan’s 10-year yield mostly hugged a 20-basis-point band around the 0% target since YCC was rolled out.
(Click here for an interactive graphic of Japan’s JGB yields since early 2016: https://tmsnrt.rs/2May3Ye https://tmsnrt.rs/2May3Ye)
The BOJ will thus discuss ways to allow 10-year yields to deviate more from its target at the March review, sources have told Reuters.
Allowing yields to rise more would help make YCC more sustainable, as vaccine rollouts could drive up economic growth, inflation and long-term rates in the coming months, analysts say.
But if the BOJ allows rates to fluctuate more widely, it risks undermining the credibility of YCC.
“If the BOJ is being forced to allow yields to move at a wider range around its target, it shows that markets are deciding the shape of the yield curve and that there are limits to the BOJ’s ability to control it,” said former BOJ deputy governor Hirohide Yamaguchi.
“It’s hard to control long-term interest rates within a tight range for a long period of time.”
(Additional reporting by Balazs Koranyi in Frankfurt and Howard Schneider in Washington; Editing by Jacqueline Wong)
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