Risk markets need to keep an eye on bond yields

It is hard to find headlines focusing on ’doom and gloom’ with attention instead on another liquidity fuelled rally for risk assets. The liquidity fuelled party is only getting started as markets expect a large take-up at the next 3-year LTRO from the ECB…

…growing expectations of QE3 from the Fed, a BoE that is likely to deliver an additional 50bn in QE next week, and a BoJ that will likely do more QE in order to allow the MoF to pull the intervention trigger on USD/JPY.

This has uncanny similarities to what transpired in Q1 2009 when global central banks delivered not so much coordinated but coincidental policy easing. The fact that we are on a long and painful deleveraging road means that it won’t be the last time we see a liquidity fuelled rally in support of asset prices. The common denominator in these episodes is that risk-on tends to follow a period of a scramble for quality, safety and liquidity.

Liquidity helps assets but not economic outlook

Monetary easing at the zero bound on nominal interest rates is essentially a debasement of money and it is this that drives investors from cocoon type behaviour into attempting to earn a return. As risk assets rally and the headlines are increasingly dominated by such gains those looking to stay on the sidelines find it increasingly hard to ignore risk-on. For now the rally is more about a short covering as opposed to an active chasing of returns.

Markets remain sceptical largely because the fundamentals have not changed with leading indicators still suggesting a slowdown in the global economy, a eurozone still not facing up to the solvency problems of its sovereigns and banks and a US housing market that is showing signs of renewed weakness. The structural headwinds still suggest that the monetary easing while ramping up asset prices will not have a significant and lasting impact on the economic outlook.

Watch yields to gauge sustainability of risk-on

There remains a fear from investors that risk markets might explode to the upside (see “Fear that markets may melt-up”; Jan 19). The uncomfortable choice for investors is whether to ride the risk-on wave and hope to get out early or stay on the sidelines and look to earn a low/stable nominal return. How much money is forced from the sidelines will likely depend upon how badly bonds perform and so far this year government bonds have managed to hold their gains.

10-year yields on UK, US and Germany are +7bp, -6bp and -6bp respectively so far this year while in Jan-Feb 2009 (S&P500 bottomed on 6 March 2009) the performance was +58bp, +65bp and +13bp respectively. If bond markets start to perform badly over the coming weeks then we could see a more sustained rally on risk assets that goes beyond a short covering and low volume rally.