Sunday, 6 January 2013


'Risk-on/risk-off" is nearly as annoying as the fiscal cliff, in terms of over-used expressions used by  those who work or play in financial markets. But while it would be premature to say Ro-Ro is dead, I am confident that a shake-up of the cross-makret correlations which are currently seen in market,s is on the way.  

Cross-asset correlations are nothing new and most are easily explained. Since 2006, for example, there has been a strong,and logical correlation between the level of the Japanese Nikkei index, and the Dollar/Yen exchange rate.  Logical because Japanese exporters' earnings are obviously affected by the value of the currency - a weaker yen means stronger earnings for many bellwether names.

I can play silly games with this correlation too: Dollar/Yen is also closely correlated with the level of US bond yields. Why? Because the willingness of Japanese investors to re-cycle the accumulated financial surpluses of the last few decades, is determined in no small degree by the yields they can get abroad, and US Treasuries are the driver of those. But these two correlations taken together mean that there is a strong and utterly spurious relationship between US bond yields and the Nikkei. Rising US bond yields do not imply that Japanese companies are doing better, except insofar as both reflect a healthier global economy.

There are plenty of these correlations around, but in recent years, they have all been dwarfed by 'risk-on/risk-off'. That is a world which is either 'risk on' and any higher-yielding, more volatile or generally riskier asset does well, or 'risk off', when investors are hiding under rocks, and about the only things which thrive are the dollar and US Treasuries.

For a fund manager, this is frustrating. Brought up to look for ways to build better risk-adjsuted investment portfolios, the fund manager finds instead a world where you have to accurately choose between the equivalent of red and back squares on a roulette table.

The 'risk-on/risk-off' world is a result of Federal Reserve policy, which has caused a breakdown in the relationship between US interest rates and economic activity. The Fed keeps rates at zero, and add as much money to the economy as possible through QE, irrespective of the economic data. So 'good' US economic data don't trigger a re-think about Fed policy or a rise in Treasury yields. Instead, they make investors less afraid of recession, and more desperate to earn some kind of return on their money.

The daftest consequence of all is in the currency market. "Good" economic data in the US don't make anyone think the Fed will raise rates, they just make them less gloomy about investment returns. So good news for the US is bad news for the dollar. Which would be weird were it not for the fact hat the US authorities are pretty happy with a soft dollar anyway.

Regimes come and go, of course. And so will "risk-on/risk-off". It will change when the US economy has enough traction that the normal relationship between Treasury yields and economic activity is restored. That won't only happen when the Fed talks about raising rates,  but when people in the markets dream about the notion that the Fed might contemplate the thought that they could perhaps, just perhaps raise rates, one day. When so much money is riding on the same bet  - that rates are low for ever - it won't take a solid silver economic recovery to swing market sentiment, just a series of better economic releases, a bit of a debate at the FOMC and a shift in consensus expectations of US growth to, perhaps, 2 1/2-3% or so.

And what then? Higher US yields, for sure. 2-year rates will need to build in a risk premium. 30-year yields will need to price in the likelihood that the first change will be an end to Fed buying. The dollar will then benefit from good news. As for equities, credit and volatility, frankly, who knows? Better economic news is 'good' for them but higher US rates are 'bad'. And there is a huge amount of money invested now in correlations that are a few years old, but won't last for ever.  In many ways, a stock-picker will do better than someone guessing where the overall market goes in this world. And hurray to that because what all this means is that there will be winners and losers and smart investors will be able to start building portfolios with decent risk-reward characteristics.

So when? This year but not right now. The Fed isn't about to change tack, or even hint about a possible change of tack. Ben Bernanke is still the King of easy money.
But we have had a taster in recent days of how the world is changing as economic divergence between Europe and the US becomes the single biggest macro story out there.  If US debt ceiling talks don't change the gentle thrust of US fiscal policy, and if the European recession doesn't de-rail anyone else, US growth forecasts will be revised up. And then we'll see what the second half of the year brings. Markets are forward-looking and the outlook is getting a little less bleak.

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