Pricing of risk is about to change

One of the hallmarks of the ongoing economic recovery has been the narrowing of yield spreads. In 2007, before the wave of collapses hit the banking sector, something happened in the bond and swap markets.

Yields spreads between government bonds and corporate/mortgage bonds increased and the prices of CDS's moved up significantly. Similarly, the TED spread, the difference between the USD interbank 3 month rate and the yield on 3-month US government bills, had increased. With the benefit of 20/20 hindsight, HSBC's decision to pull out of the US lending business following massive losses on Subprime loans marked the beginning of this development.

Since the rescue packages began to be implemented, the credit spreads and the CDS prices have fallen almost in a straight line. Ample liquidity in the banking sector has pushed the risk tolerance back up and some yield spreads have fallen to pre-crisis levels. In the past days, several of these key risk indicators have gone in the reverse.

So the movements over the recent days are an early warning that things may be about to change. It could be that we are on our way back to normal. The "normal" state of things is of course that yield spreads or CDS's should accurately reflect the default risk related to the individual issuer. This simple truth has not really been the case in the past couple of years.

Some events are now bringing home the truth to the markets. A high profile near-default (Dubai), some well-reported problems with an EU-member (Greece), and massive issues of corporate bonds have all contributed to an increasing nervousness.

In a broader perspective, the global economy is moved towards recovery, and the financial markets are well past the point where the dominant driver was the relief that we were not all going bust.

Instead, the financial markets are now driven by more everyday factors: Growth, profitability, valuations, monetary policy, inflation expectations, market issuance.

While these factors are standard fare, one of them, the monetary policy, is definitely not "standard" at all. It is explosively aggressive and even the most ignorant market participant knows well that it will not continue. And we all know that treasury bonds will swamp the market later in 2010. Corporate issues are already strong due to the reluctance of banks to lend money.

The question is whether there is anything to be nervous about. The answer is not quite as straight-forward as it would seem. General yield levels are not determined by supply and demand. It is determined by savings and investments in the society as a whole. If there is not enough saving to support the investments, yields will go up and vice versa.

At this moment in time we may well be facing a huge increase in government issues. But at the same time, consumers all over the world are saving or reducing their debts. As long as that is the case, there should be no reason to fear significantly higher bond yields. They may indeed fall in the short term despite market jitters.

Instead we should focus on the link between the ample liquidity and the risk premium. The risk premia have been driven down by excess liquidity. We all know that the excess liquidity will be drained out of the market at some point in time. So yields spreads should indeed increase. Does that mean that the market is getting more risk averse? Probably not, but it means that the price of risk is about to change.