Retreat of Tail-Risk Trinity

March 15, 2012

Until this week at least, one of the big puzzles of the year for many investors was squaring a 10-15% surge in equity indices with little or no movement in rock-bottom U.S., German and UK government bond yields. To the extent that both markets reflect expectations for future economic activity, then one of them looks wrong. The pessimists, emboldened by the superior predictive powers of the bond market over recent decades, claim the persistence of super low U.S. Treasury, German bund and British gilt yields reveals a deep and pervasive pessimism about global growth for many years to come. Those preferring the sunny side up reckon super-low yields are merely a function of central bank bond buying and money printing — and if those policies are indeed successful in reflating economies, then equity bulls will be proved correct in time. A market rethink on the chances for another bout of U.S. Federal Reserve bond-buying after upbeat Fed statements and buoyant U.S. economic numbers over the past week also nods to the latter argument.

But as we approach the final fortnight of the first quarter,  more seems to be going on. Much of the whoosh of Q1 so far has merely been a reversal of the renewed systemic fears that emerged in the second half of last year. In fact, gains in world equity indices of circa 13% are an exact reversal of the net losses suffered between last June and the end of 2011.  And if those gains are justified, then much of the extreme “tail risks” that scared the horses back then must have been put to rest too, no? Well, the two mains tail risks — a euro zone breakup or collapse and a lapse of the U.S. economy into another recesssion or depression — do look to have been been put to bed for now at least. The ECB’s mega 3-year cash floods in December and February and the “orderly” Greek debt default and restructuring last week have certainly eased the euro strain. The remarkable stabilisation of U.S. labour markets, factory activity, household credit and even retail sales has also silenced the double-dippers there for now too.

The net result seems to have been this week’s synchronised retreat in three of the main “catastrophe hedges” — gold, AAA-government bonds and equity volatility indices — and this move could well mark a critical juncture. Gold is down 8% since its 2012 peak on Leap Day,  10-year U.S., UK and German government bond yields are up 25/30 basis points since Monday alone, and equity volatility gauges such as Wall St’s ViX have dropped to levels not seen since before the whole credit crisis exploded in the summer of 2007.  If extreme systemic fears are genuinely abating and the prevalence of even marginal positioning like this in investment portfolios is being unwound, then there may well be some seismic flows ahead that could add another leg to the equity rally.  The U.S. bias in all this is obvious with the rise of the dollar exchange rate index to its highest since January. That has its own investment ramifications — not least in emerging markets. But the questions for many will remain. Is the coast really clear? Are elections over the coming weeks in France and Greece and an Irish referendum on the euro fiscal pact just sideshows? Is the global economy sufficiently repaired to bet on renewed growth from here and will corporate earnings follow suit? Has bank and household deleveraging across the western world halted? Are the oil price surge and geopolitical risks in the Middle East no longer a concern? And if you’ve made 10-15% already this year, are you going to go double or quits?  The chances are there will not be 10-15% equity gains in every quarter this year.

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