Perhaps one of the more surprising aspects of markets in
recent weeks has been the extent to which they have remained resilient in the
face of what might be termed extreme provocation. Admittedly there was something
of a wobble around the time President Trump decided to end US participation in
the Iran nuclear deal, but on the whole they have remained remarkably quiet.
Add in the prospect of unrest on Israel’s borders and the ongoing situation in
North Korea, and it is clear that there are plenty of geopolitical threats to
worry about (not to mention the very fact that Donald Trump occupies 1600
Pennsylvania Avenue).
Not so many years ago, these were the kinds of issues that
would have investors running for cover. But equity option volatility continues
to ease back and is well below the levels achieved in early February which is a
sign of reduced tension. Indeed, the FTSE100 yesterday hit an all-time high, although
this was primarily the result of a weaker pound that boosts the sterling value
of foreign currency earnings in a market which generates 70% of its revenue
abroad. Nonetheless, it does raise a question of why markets can continue to remain
steady in the face of numerous headwinds.
One reason is that central banks in Europe and Japan
continue to provide huge amounts of liquidity. In European bond markets, the
central bank remains a huge buyer and it is almost impossible to get hold of certain
bonds – particularly corporate securities – due to the ECB’s actions. Against
this backdrop there is little reason for markets to panic in the face of events
that may – or may not – cause prices to fall. This is entirely rational
behaviour. If investors believe there may be a small dip in prices that will
subsequently be reversed as the central bank backstop kicks in, it makes sense
to hold onto positions and thus save the trading costs associated with closing
them and reopening them again. In other words, markets can be afford to be
brave in the face of these threats. But how long might such behaviour persist?
In the US, the Fed has raised rates six times since December
2015, by a total of 150 bps, and it is winding down its balance sheet, so the degree
of support which it once provided is being slowly eroded. We are starting to
see bond yields creep up with many investors concerned by the fact that the US 10-year
yield has hit a new multiyear high, returning to a level not seen since 2011 (3.128%).
It is hard to say why rates have edged up so quickly of late but then it was
equally difficult to explain why the long end of the curve did not respond as
monetary policy was tightened. They are probably now where they should be. In
the process, the differential with German Bunds has widened out to around 260
bps – a spread last seen in the late-1980s. So long as the ECB is still engaged
in buying Emu bonds, there is little prospect of a substantial narrowing. But
before too long – perhaps once the ECB buying programme ends – European yields
will also begin to rise. Indeed, Italian yields are already edging up as political
concerns mount regarding the formation of a new coalition government.
It currently feels as though we are in the midst of a phoney
war as markets digest the implications of Fed tightening. They don’t want to
sell because a strategy of shorting the market has not paid off over the past
nine years. But as the Fed increasingly normalises monetary policy and the ECB
contemplates an end to its QE programme, the special conditions which have
supported valuations, and prompted a divergence in asset prices from fundamentals,
may well force investors to take a closer interest in some of the global
threats which are bubbling up. And they may not like what they see.
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