Getting Close To A Bottom, But We're Not There Yet

Do click to enlarge but what you’ll see is risk assets like US high yield, energy stocks and brent (at $80 yet?) getting hit while FX and peripheral Eurozone bonds, for the most part, have been admirably steady. For the lack of something more compelling, Nomura blame the lack of a clear liquidity backstop, QE4 notwithstanding, and global growth concerns, old-hattedness notwithstanding:

Nomura went on to say that the current risk-off environment is nothing to get worried about, largely because liquidity in the banking system remains ample and there is little risk of financial contagion (emphasis added):

Nevertheless, there is no doubt that many investors seem to be in full-on risk reduction mode currently. We are currently receiving a steady stream of questions about how bad it can get, with comparison to the 2011 sell-off and suggestions that QE4 may be needed. This illustrates how quickly sentiment has swung.

While we are concerned about the setup for risk assets in general this quarter, due mainly to liquidity and valuation considerations, we are less concerned about the actual impact of recent market dynamics on key global economies, for a number of reasons.

First, the type of risk aversion we are seeing now is not necessarily that powerful from a financial conditions perspective. Banks are actually outperforming in the sell-off, and liquidity indicators are well behaved. For example, dollar funding markets are stable, and short-duration credit instruments are holding firm, while the move in swap spreads has been moderate (relative to VIX moves). Hence, while high yield spreads are meaningfully wider (from a low base), it is not clear at this point that there will be strong feedback into the economy through tighter credit conditions. In fact, in the US, you can argue that lower mortgage rates will be a boost to an important component of the credit spectrum.

Second, the big move in oil prices can be interpreted in various ways. A delayed reaction to increased US supply? A function of weakening global demand? Due to Libyan production surprising to the upside? There will be winners and losers from this price shock (see Dissecting the Commodity Shock, 9 October 2014). But generally, the Eurozone and the US will see consumption potentially somewhat boosted by this dynamic, simply because the terms of trade are being boosted.

All told, there may well be a gradual downtrend in global growth, driven especially by EM growth trends. But it is unclear that the recent market tension is of a type that will put us into a downward spiral, as was the case during the Global Financial Crisis and during the Euro crisis.

The whole risk-off episode may have been sparked by fears of a US junk bond liquidity at PIMCO (via Dealbook ):

When it comes to high-risk bonds, the asset management giant Pimco has pretty much cornered the global market.

Be it bonds issued by the automotive financier Ally Financial or the student loan financier SLM in the United States, or government bonds in Spain and Italy, Pimco holds a commanding position in these high-yielding securities.

But as Pimco’s portfolio managers double down on their bet that high-risk bonds will thrive in a world of low interest rates, a growing number of global regulators are warning that the positions being taken on by the big asset management firms pose a broad danger to the financial system.

These concerns were amplified this week as stock markets gyrated, the yields of high-risk corporate and European bonds spiked upward and, crucially, trading volumes evaporated.

Regulators and bank executives have cautioned that an accumulation of hard-to-trade, risky bonds by a small group of fund companies could turn a bond market hiccup into a broader rout, in light of how illiquid many of these securities have become.