Global Agenda: Sentiment pendulum

Volatility is now the dominant feature of the markets.

By PINCHAS LANDAU
November 15, 2007 22:03
3 minute read.
Global Agenda: Sentiment pendulum

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Volatility is now the dominant feature of the markets, with prices increasingly making sharp moves, usually in opposite directions from one day to the next. The multi-hundred point rises and falls in the Dow Jones Industrial Average are the most prominent example of this syndrome, but they are merely typical of what's happening generally - and not just in equity markets, but in almost all the markets. Nevertheless, beyond the day-to-day swings there are clear trends at work. In fact, the primary trend discernible in most of the markets is the very factor that is generating the massive volatility, namely the rising level of fear. Whether as an effort to be politically correct or to be pseudo-sophisticated, the term in use in professional circles is "risk-aversion," but for normal people who speak regular English, the word is fear. Investors of all stripes are becoming more averse to risk, i.e. more afraid. In itself, this is hardly surprising - if only because the degree to which risk was being ignored in 2006 and early 2007 was virtually unprecedented and could hardly be exceeded. There are some markets, notably among the various classes of bonds and other securitised debt, which have witnessed a massive swing from the extreme of totally ignoring risk and failing to price in any risk premium, to the opposite extreme of regarding everything as extremely risky and hence unbuyable at any price. These markets have simply stopped functioning as a mechanism for determining prices - which is what markets are supposed to do. This situation is more likely to occur in markets that are inherently illiquid, such as real-estate, and in those financial markets where a few key players are dominant, such as the more exotic forms of debt. It is unlikely in more liquid markets, such as equities, government bonds and, above all, currencies - the last being the most active and liquid financial market in the world. Here the rise of fear has translated into greater volatility, but the markets keep functioning smoothly in terms of their ability to match buyers and sellers. But the currency markets also reflect, better than anywhere else, the wider impact of the return of fear, sorry - risk-aversion. In the good old days, prior to July 2007, when nobody cared about risk and the only thing that mattered was return, the biggest and best game on earth was the carry trade. This involved borrowing money in a currency with low interest rates and investing it in a higher-yielding vehicle - whether that was a different currency, or a bond carrying a high yield, or shares, or whatever. The simplest form of carry trade was to borrow yen, the currency with the lowest interest rates in the world (zero until last year, now 0.5 percent) and invest the proceeds in Australian or New Zealand dollars, which offered very high interest rates. An alternative and more conservative form of the game was to borrow Swiss francs and use them to buy euro or, better, sterling, and pocket the higher interest rate. Since everybody was doing this, the prices of the yen and Swiss franc kept falling - making the deal much more profitable, because there were now capital gains as well as interest rate differentials. That's how the Swiss franc fell from 1.45 to the euro a couple of years ago to 1.68 earlier this year, and how the yen fell sharply against every other currency - even the US dollar. While the greenback fell against the euro, sterling and all the rest, the yen fell to as low as 123 to the dollar. With greed in uncontested dominance, only returns mattered and fear had been banished. The second half of 2007 has seen the resurrection of fear, big time. As the scale and scope of the financial disasters piled up by the greed artists during their glory days becomes clear, the process of "unwinding" the carry trade has picked up steam. The key facts haven't changed: the yen still pays virtually nothing and the Swiss franc pays little, while the Aussie and Kiwi dollars and sterling (and the Scandinavian currencies) still offer high rates. The rationale for the carry trade is intact, but the incentive to indulge in it has been significantly diluted. Sentiment, that abstract concept that cannot be properly measured but can always be felt, has changed completely. Risk is out, safety is in - and the direction of the yen has become the global weather-vane for risk sentiment on a daily, and even hourly, basis. landaup@netvision.net.il

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