Review of the troops after the liquidation

Posted on 01. Jul, 2013 by Jean Jacques Ohana in Weekly Focus | Comments Off

The global selloff which hit all asset classes at the same time made significant damage in term of financial stability.

As stated by Riskelia since March 2013, many assets were in bubble territory, in particular risky debts and equities. As showed in figure 1, equities’ exuberance is presently over.

Liquidity has clearly tightened in key systemic links of the financial system but is now in neutral territory. It means that the financial picture is more unpredictable than before but still not in distress (figure 2).

The dismal performance of the risk parity strategy sheds light on the nature of the liquidation. The risk parity strategy allocates the risk evenly across different types of asset classes, for example equities, commodities and the so called fixed income futures (US, UK, Germany). The rationale behind such a strategy is to capture the risk premiums which materialize in different macroeconomic scenarios: growth with equities, inflation with commodities and recession / disinflation with fixed income. This strategy is usually dubbed an “all-weather” strategy as all assets classes present a long term risk premium while performing in opposite macroeconomic environments. The strategy presented in figure 4 helps understand the damage of the liquidation. The simultaneous drop in equities, commodities and fixed income assets has produced a drawdown which is equivalent in magnitude to the ones of 1994 and 2001, but well below the drawdown of 2008.

The global selloff looks like the concerted drop in 1994 rather than the ones of 2002 and 2008 where the trends of safe haven bonds remained in positive territory (figure 5). Therefore, the correct interpretation of the selloff is clearly the perception of a more hawkish Federal Reserve. This provoked a broad based rise in worldwide bonds’ yields and a downward revision of inflation anticipations, which in turn produced a surge in real rates (figure 7) and weighed on growth expectations and risky assets.

The backstop of central banks to contain the liquidation damage will rely on declaring more explicitly that short term interest rates will not be hiked any time soon in the US and fostering higher inflation anticipations in Japan and in Europe. Therefore, the communication of Central Banks to regain control of the bond market will be critical to stop the liquidation process. . The increase in long term yields conveys the anticipation of a Fed’s rate hike, as reflected by the Eurodollar curve (figure 8). Some initiatives were undertaken in the US to link monetary tightening to tangible unemployment decrease (6.5% unemployment to remove the QE then 5.5% to increase the Fed target rate). In Japan, the BOJ is still committed to a record Quantitative Easing. In the Eurozone, the ECB goes on surfing on the “OMT” announcement but the Eurozone assets will probably need unconditional QE to be stabilized.

The scenario nobody considers is the following: what if central banks fail to take back control of the bond market? Under this scenario, the only solution will be to raise cash and wait that the increase in real rates destroys growth and risky assets so much that… interest rates fall back.

 

 

Figure 1: Riskelia’s bubble indicator on a world basket of 12 stocks indices. The Bubble Indicator reflects bullish or bearish herding behavior.

It is only based on market prices and scores the regularity of the price moves on various time frames.

Figure 2: Heat map of risk aversion indicators across various neuralgic premiums of the financial system.

For a given asset class, the risk aversion indicator rates the reward market participants require for risk taking. The scores are expressed in numbers of standard deviations to a set of moving averages (from 3 months to 2 years). They are averaged into a Global Risk Indicator representing the global level of risk aversion in the market.

Figure 4: long term performance of the risk parity strategy and historical drawdowns

Figure 5: Average trend indicator on equities, commodities and safe haven bonds.

Figure 6: Average trend indicator on all assets.

Figure 7: US Nominal, real and breakeven 10 year rates

Figure 8: Interest forward curves on 1st May 2013 and 28th June 2013: 128 bps of additional Fed tightening in 2017-2018

 

 

 

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