Monday, 17 October 2011

Risk willingness increases

Despite the continued uncertainty over what will actually be done in order to stabilise Greece and the European banks, G20 meeting in the weekend 15/16 October delivered enough details and pointers that the financial markets will begin taking the risk premium out of the market. Later on, it could develop into some kind of euphoria that will turn upside down everything that has happened in the past few months. It started two weeks ago as the first rumours of a comprehensive solution began to circulate and it can continue for a while, at least.

Bank crisis solution
Our often repeated take on the situation is that at least two crises overlay each other: Greece, and a general debt crisis, which in turn reflects itself in a very unhealthy banking sector. As I have stated earlier, Greece must have a debt restructuring in order to get out of the mess, and that will lead to some serious cash injections to the banks. The US banks already got their no-strings-attached social help three years ago, and the European banks will probably receive their gift vouchers over the coming six months. 

A classic “risk-on” reaction
In concrete talk, “taking the risk premium out” means: 
  • Stocks will gain, possibly lead by the bank stocks, and primarily in Europe. 
  • Bond yields on higher-rated sovereigns will increase, the yield curve will steepen.
  • Yield spreads of lower rated sovereigns over higher-rated sovereigns will narrow, in some cases sharply. 
  • High yield bonds will see the their yield spreads over government bonds narrow but at a slower pace than what happens in the spread between high and low rated sovereigns.
  • Dollar will weaken against the Euro and so will other “safe” currencies.
  • Commodity currencies will increase against the USD.
  • Commodities (primarily industrial commodities) will rise moderately, and oil will receive a boost.
  • Gold may fall further, as the “safe haven effect” vanishes.

It may look like an asset rotation, but we not yet seen market volumes corresponding to a major move of capital between asset classes.

A new divergence is building
A bit further out another theme is building. The markets had not seen the sharp slowing of the global economy as late as one week before the stock markets fell out of bed in early August. “The End of the World” is still very much on everybody’s mind.

At some point the markets will realise that apocalypse is not now! Nor indeed anytime soon. The risk-on scenario will then be followed by a proper risk-rally. It will probably last for some months before the underlying longer-term problems again are taken seriously. The debt crisis has not gone away, and it will continue to subdue growth for the coming years. It will be uncomfortable (particularly if you work in a bank), but not disastrous. 

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