What does risk-off actually mean?

by Shaun Richards

Today I intend to look at a subject which gets bandied about a fair bit but is not always well explained. Along the way we find that some of our regular themes and subjects are in play here. Whilst the concept of risk off may look simple we have learnt in the credit crunch era that such things rarely are as we introduce the issue of perception. One man or woman’s risk-off may seem rather risky to others. Also we have been taught that things that the finance equivalent of economics 101 would tell us are risk-free in fact are not. So let us advance cautiously.

Sovereign bond markets

There was a perception that these were risk-free although as someone who worked for many years in them I was only too aware that you could lose money in them. The bond market in my country the UK saw several solid falls in my time meaning that investors lost money. The risk-free element here was that you would always get your nominal amount back at the maturity of the UK Gilt. Although that always was something of an Ivory Tower definition as in the meantime inflation could and in the UK’s case is usually very likely to eat into the real value of your investment and foreign investors also have a currency risk. As over time the UK Pound £ has tended to depreciate then on average you would be a loser here.

At this point we see that “risk-free” was never really that anyway. Those who recall the heights of the Euro area crisis will recall the European Central Bank insisting that Greek government bonds be recorded as risk-free in banking accounts, or more specifically a risk-weighting of 0. This was something of a further swerve as the ECB with its many national treasuries is not linked to them in the way that most central banks which only deal with one are.

Be that as it may central banks have advanced the case of sovereign bonds being risk-free by the advent of the QE ( Quantitative Easing) era where they have bought them on an enormous scale. This has two main features, investors tend to be too busy congratulating themselves when large profits are made to worry much about the risk assumed. Next comes the concept of the world’s main central banks being effectively buyers of last resort for sovereign bonds and thereby providing a put option for the price. On this road we see that whilst in theory the risks have got higher in practice they may well have got lower because the central bank will not allow falls. The latter argument is reinforced by those of us who believe they cannot do so without revealing that they have not achieved the successes they claim.

Today

The thoughts above are highlighted by the fact that sovereign bond markets have been rallying strongly again over the last week or two. The risk-off theme has seen them rally in a new version of what used to be called a flight to quality. We have learnt that bonds may not be quality but that has been anaesthetised by the likely reality of central bank action. Putting this into numbers the US ten-year yield is 2.37% as I type this compared to this on the 22nd of March.

I will come to the cause of this in a moment but if we stick with the event we see that the ten-year US Treasury Note now yields 2.5%. The Trump tax cuts were supposed to drive this higher as we note that it was 3.24% in early November last year.

This type of risk-off trade has also been seen elsewhere as for example the UK ten-year Gilt yields 1.04%. This has mostly been missed in the wider debate as the UK could plainly borrow if it chose but we seem locked into a belief that borrowing is unaffordable when it is the reverse. The headliner in terms of numbers is Germany which has a ten-year bund yield of -0.11% and therefore is actually being paid to borrow all the way up to the ten-year maturity. Japan is the same although the negative yield is smaller.

Currencies

There are currencies which are perceived to be safe havens and thus see a flow of buying when fear appears. The stereotypes for this were the German Deutschmark and the Swiss Franc. In more modern times not only has the Euro taken over the role of the Deutschmark in the main but we have seen the Japanese Yen not only join the list but often be at the top of it. The present state of play is summarised by Dailyfx.com below.

The Japanese Yen’s current backstory is of course fundamental, with risk aversion stemming from increased US-China trade tensions supporting what is, after all, perhaps the quintessential anti-growth currency play.

The US Dollar has haven appeal too, of course, but the Japanese Yen is certainly beating it at present, with USD/JPY having wilted very sharply back to lows not seen since the start of February.

As they point out the picture is muddied by the fact that there are times that people go “holla dollar” or as Aloe Blacc put it.

I need a dollar dollar, a dollar is what I need
Hey hey
Well I need a dollar dollar, a dollar is what I need
Hey hey
And I said I need dollar dollar, a dollar is what I need
And if I share with you my story would you share your dollar with me
Bad times are comin’ and I reap what I don’t sow.
The other side of the coin is emerging market currencies which tend to be hit and at the moment our eyes are usually drawn to the Turkish Lira or the Argentine Peso. Hence the rumours out of Turkey yesterday that capital controls may be on the way as frankly there is not much else left to try.
The last couple of weeks has perhaps seen a new entry to the charts. What I mean by that is the way that the price of Bitcoin has been rallying and at times surging. As I type this it is above US $8000 on several exchanges which leaves us with plenty to mull as the last year or so has left us observing various crises in the new coin structure.
Comment
I have left to last the main other side of the coin which is equity markets which fall and the go lower. That is partly because of the ch-ch-changes here where even relatively small falls tend to have markets on alert for more central bank easing. This trend has been exacerbated by the way that US President  Donald Trump focuses on the stock market so much. However that does provide another argument in favour of bond markets as for example we have already seen the reverse QE programme called QT given an end date. I have written before that I would not be surprised if we saw more bond purchases by the US Federal Reserve in what would no doubt be called QE4. That could easily be sparked if the Chinese should start to sell their holdings of US Treasuries in any real size.
Thus we see that it is really only a perceived risk-off really and let me conclude by throwing in another factor. For some time individuals have seen foreign property investments as a type of risk-off trade but now we are seeing house price falls in many of the places they invested that may change. Although of course from the perspective of places like Argentina and Turkey that is small-fry and should things really light up again in the Middle-East many things will look relatively risk-free.
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