February 11, 2013 7:20 pm
Markets: With the volume down
Jaded traders are seeking clues that big economies are returning to solid growth
A trader reacts at his desk at the Frankfurt stock exchange©Reuters
Financial markets are not creating jobs and prosperity because they are failing to allocate capital efficiently to the economy

Politician walks out of door. Journalist puts microphone to his mouth. Politician mouths something. Markets move.” Life became rudimentary for European financial markets when the eurozone debt crisis erupted, says John Phizackerley, chief executive of Nomura’s European operations.

Gripped by uncertainty and fixated by eurozone leaders’ moves and missteps, share trading volumes have fallen sharply. Such political and economic news has increasingly driven stock and bond markets, deterring traders who would otherwise have sought profitable opportunities from big trends unrelated to the eurozone.

Volumes in the Eurofirst 300 index leading stocks have fallen more than 45 per cent from their peak in the second half of 2007. And it is not just European markets that have fallen into a funk. Although early 2013 saw share prices surging as the crisis mood ebbed, US trading volumes remain low, with daily trades down 40 per cent since the first half of 2009.

Becalmed after the crisis

Trading volumes data

Turnover in foreign exchange and credit markets has also tumbled over recent years. Measures of market volatilityhow much share prices chop and change – have fallen, while “correlation indices”, showing how different asset classes are rising and falling together, have increased. “A degree of jadedness has entered markets,” says Stacy Williams, strategist at HSBC.

After a global economic slump caused by seemingly reckless financial market activity, a period of calm might appear welcome. But moribund markets spell bad news for bank employees, and schadenfreude by others would be misplaced if they were being lulled into a false sense of security.

Individual investors are in for a roller-coaster ride in terms of volatility that they are not prepared to deal with,” warns Andrew Lo, professor of finance at the MIT Sloan school of management in Boston.

Historically low interest rates orchestrated by central banks have made it difficult for investors to earn decent returns. Thinner, static markets make it harder still to eke out gains. The risk is that financial markets fail in their role of promoting job creation and prosperity by allocating capital efficiently to the real economy. Whether such trends are reversed will also determine the shape of the post-crisis financial world.

“The problem will arrive when we see a loss of risk appetite and we get a ‘discontinuous adjustment as they say – in other words, it could be vicious,” says Mark Cliffe, chief economist at ING, the Dutch bank.

The crises of recent years – in the eurozone and elsewhere – have not been the only factors depressing global financial market activity. Actions by central banks, such asquantitative easing” by the US Federal Reserve or large-scale liquidity injections by the European Central Bank, have stabilised economies – but failed to create much growth. Not only are markets less exciting, sluggish activity means less need for transactions.

Foreign exchange volumes are highly correlated to global trade,” explains Gil Mandelzis, chief executive of EBS, the trading platform. Last year trading was centred around some very meaningful events usually news of something to do with the crisis.” According to EBS data, electronic foreign exchange trading volumes were almost 30 per cent lower in the second half of last year than in the same period in 2006 – before the financial crisis erupted.

Poor economic growth has meant fewer companies listing their shares. The value of European initial public offerings fell by almost two-thirds last year compared with 2011, to just $14bn, according to Dealogic data. With fewer fresh supplies of equities, and companies buying back shares, trading in markets has inevitably fallen.

Also depressing activity has been a regulatory onslaught aimed at making markets safer. Banks are having to hold more capital to trade; in corporate bond markets, investors fret that banks have scaled back their market making so much that it would be hard to sell if sentiment turned suddenly. Europe has seen intermittent bans on “short selling” – selling assets you do not own in the hope of buying them back at cheaper prices.

Regulators are demanding that trades in derivatives such as credit default swaps (CDS), which protect against default, are backed by adequate collateral or security. Global trading in CDS has fallen by about 18 per cent compared with mid-2010, according to data from the Depository Trust & Clearing Corporation.

Similar factors explain rising cross-market correlation indices. Markets have all focused on the same big issues: currently, whether the world’s advanced economies can return to solid growth. Recent years have been characterised by switches between “risk on” and “risk off” – or between buying riskier assets and heading for havensdepending on the prevailing sentiment.

Correlations are high for good reasons. Equities, bonds and currencies are all going up and down together because they all depend on the global recovery,” says Mr Williams. HSBC’srisk-on, risk-offindex, which measures the extent of cross-asset correlations globally, remains elevated even after this year’s share rally.

A more controversial issue is whether correlations have risen be­cause of computerised, “high frequencytrading executed in fractions of a second. Technology has encouraged high-volume, low-margin business models based on exploiting short-term trends, and broken down distinctions between different financial products by encouraging complex products that bridge traditional distinctions.

High-frequency traders, however, deny that their computer algorithms have the effect of pushing markets all in the same direction. “If we were truly able to both cause correlations and profit from it, we would be making infinite amounts of money, which we are not,” says Remco Lenterman, managing director of IMC, a high-frequency trading company, who speaks on behalf of the sector.

. . .

Whatever the precise causes, lacklustre markets have hit jobs in finance. Employment in London’s wholesale financial sector will drop to 237,000 this year, down a third from a peak in 2007, says the UK’s Centre for Economics and Business Research. Yet a lesson from the crisis is that banker happiness levels are not necessarily positively correlated with future economic growth prospects.

Things that worry banks are on the whole good for us. It is the things that don’t worry banks that we should watch out for,” says Andrew Smithers, founder of Smithers & Co, the economic advisers.

If low volumes mean more stable trading conditions, this should logically be good news for “end users” of capital markets, such as companies thinking of raising equity. A “risk-on, risk-off herd mentality could create opportunities for active investors who take the time to scrutinise fundamental factors that should determine bond or share prices over the long term. “It suggests things are being mispriced. If your valuation model is good and seriously applied, then rising correlations are a wonderful opportunity,” says Paul Woolley, senior fellow at the London School of Economics.

Nevertheless, bankers and financiers are certain that their woes matter for the rest of the economy.

Economies benefit from viable, liquid and transparent capital markets,” says Mr Phizackerley of Nomura. “We want Europe to go head-to-head with the US and Asia. We don’t want it to be shrunk to some kind of backwater.”

Even if higher correlations create opportunities for active, long-term investors, it is harder to justify the immediate cost of extensive research in this environment. How can you charge a fee if you are selling different shades of grey?” asks Ramin Nakisa, strategist at UBS.

Investors have been attracted increasingly to low cost, index-trackingexchange traded funds” as a cheaper way of riding market trends. Higher correlations across asset classes make it more difficult to diversify portfolios, a traditional strategy for improving the balance between risks and rewards. If that makes investors more hesitant, flows of capital to the real economy would be further constrained.

A bigger concern is that markets are simply enjoying a calm period before the next storm. The rise in correlations is not a problem in itself, “it is the reason why correlations have gone up that we should worry about”, argues Mr Smithers. “The really dangerous thing that is going on at the moment is that central bank policy is increasing the risk of another crisis.”

Arguing that fresh turmoil looms ahead seems odd when global stock markets are enjoying a rally and measures of market volatility have fallen. The CBOE Vix index, the flagship Wall Street yardstick of expected US share market turbulencedubbed the USfear index” – remained surprisingly subdued last year even as the eurozone crisis intensified and the US faced its fiscal crisis. This year, it has fallen to levels not seen since before the financial crisis erupted.

. . .

But the headline Vix index, and Vstoxx, its European equivalent, which has behaved similarly, measure implied volatility levels expected only over the month ahead. Measures of expected market volatility over longer periods are noticeably higher. “The market tells you that at the moment we’re on an even keel, but in nine months’ time there could be an upset,” says Mr Nakisa.

Robert Brown, chairman of the global investment committee at Towers Watson consultancy, which advises sovereign wealth funds, says: “The actual level of true volatility in the sense of global political and economic risk is higher than what is reflected in short-term market volatility. The danger is that people get lulled into a false sense of security.”

There are plenty of possible events that could trigger fresh turmoil, from unexpected shocks to the global economy or setbacks in the eurozone, US or elsewhere. Another worry is that, despite all their efforts, regulators have failed to make the financial system safer.

Systemic stability remains work in progress,” warns Mr Cliffe of ING. “The kinds of structural changes that we have seen in financial markets suggest that asset market volatility, which triggered the crisis, could actually get worse.”

There have been signs of improvement. Warnings about future turmoil might be too gloomy, creating opportunities for those who place trades on volatility indicators. Foreign exchange markets sprang back to life in January thanks to talk of a “currency warfought by the world’s central banks, led by Japan’s. Foreign exchange volumes on EBS, the trading platform, were 22 per cent higher in January than a year earlier, although that might reflect EBS’s strength in yen transactions. Equity trading volumes have edged higher, encouraging optimists to believe gradual improvements in the economic outlook will soon feed through into healthier financial markets.

But not everyone is convinced. The lesson of history is that after financial crises, market edginess is long lasting, says Prof Lo.

“The same happened after the 1929 crash. It eventually calms, but I expect that we have at least three to five years until we see the financial and regulatory landscape settling down.”

Copyright The Financial Times Limited 2013.

The Battle of the Bond Benchmarks
Jeffrey Frankel
11 February 2013

 This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

TOKYOSome prominent institutional bond investors are shifting their focus from traditional benchmark indices, which weight countries’ debt issues by market capitalization, toward GDP-weighted indices. PIMCO, one of the world’s largest fixed-income investment firms, and the Government Pension Fund of Norway, one of the largest sovereign wealth funds, have both recently made moves in this direction. But there is a risk that some investors could lose sight of the purposes of a benchmark index.
The benchmark exists to represent the views of the median investor. For many investors – both those who recognize their relative lack of sophistication and those who don’tgoing with the benchmark is a good guideline. This is an implication of the efficient markets hypothesis (EMH), for example.
To be sure, EMH theorists are often too quick to discount the possibility of beating the benchmark: It should not have been so hard to figure out during the 2003-2007 credit-fed boom that countries with high foreign-denominated debt, particularly in Europe, were not paying a sufficiently high return to compensate for risk. Or, to take another (harder) call, some of these same countries’ deeply discounted bonds, after heavy markdowns, would have been good buys in early 2012.
Nonetheless, most investors do better with a more passive investment strategy, especially given high management fees and excessive turnover for actively managed funds. A benchmark index gives that option to those who do not think that they can systematically beat the median investor, and provides an objective standard by which investors can judge the performance of active portfolio managers who claim that they can. Moreover, the same weights used in the index can be used to compute an average interest rate or sovereign spread in the market, which can, in turn, serve as an indicator of investors’ appetite for risk.
Finally, a benchmark index helps active investors to devise a deliberate strategy to depart from the median investor’s view when they believe that view to be mistaken. They may think that the median investor is underestimating risk in general or underestimating the downside in countries that have some particular characteristic. For example, they may conclude that a country has too much short-term debt, foreign-currency debt, or bank debt, or inadequate reserves or national saving.
For each of these purposes that a benchmark index serves, the correct way to weight different countries is by market capitalization, not by GDP. The keeper of the index must judge which countries and bonds are in “the market” – that is, are fully investable; but that is true regardless of how countries are weighted.
The logic behind the move away from traditional bond-market indices is that, by definition, they give a lot of weight to high-debt countries, some of which may be over-indebted and at risk of default. At first, the logic seems unassailable. But, in theory, if the market is functioning well, it should already have factored in high debt levels: such countries should pay higher interest rates to compensate for the incremental risk, unless there is some special reason to think that they can service their debt easily.
An investor who believes that countries with high debt/GDP ratios are riskier than the median investor realizes is more likely to think about his or her strategy clearly if it is explicitly framed in terms of factoring in debt/GDP, rather than framed as switching from a market-cap index to a GDP-weighted index. Furthermore, how the strategy is framed may help investors to recognize that they might want to modify it (for example, if a country’s debt has an unusually short or long maturity structure).
To be sure, default risk among some heavily indebted countries, like Greece, turned out to be higher than expected. But there is always a danger of fighting the last war. Many major middle-income countries have paid down much of their debt over the last decade, attaining indebtedness ratios far below those of advanced economies.
That point is worthy of closer consideration than it has received. As the chart below shows, major emerging markets have relatively low debts (the first bar for each country) relative to GDP (the second bar). Russia’s sovereign debt, for example, is now below 7% of GDP.
[For a high-resolution version of the chart, click here.]

As a result, the supply of these countries’ bonds is limited. If global investors switch from market-cap-weighted to GDP-weighted investing, high demand for such countries’ bonds may drive their interest rates to unnaturally low levels, setting off new credit-fed boom-bust cycles in their economies.
Moreover, many emerging-market countries have paid down debt denominated in dollars or other foreign currencies, while continuing to borrow in their local currencies. Relatively large countries, such as Thailand, Malaysia, Brazil, and South Africa, have little dollar-denominated debt left 3% of GDP or less (the dark bottom of each first bar). If an international bond benchmark is to be limited to dollar-denominated debt, GDP weights could imply a severe imbalance between investor demand for these countries’ bonds and the small supplies available.
Accordingly, local-currency-denominated debt must be included in the benchmarks. But, in that case, a portfolio reallocation away from traditional benchmark indices such as the Emerging Markets Bond Index would imply a big shift from simple credit risk toward currency risk. True, emerging-market economies’ ability to attract investment in their local currencies represents an important strengthening of the global financial system (relative to the currency mismatch and balance-sheet vulnerabilities of the 1990’s). Nevertheless, investors who switch from one “benchmark” to the other need to be aware of the extent to which the reduction in default risk comes at the expense of heightened exposure to currency risk.
In short, it is not crazy for an investor to depart from a market-cap-weighted benchmark by putting more weight on countries with low debt/GDP ratios and less weight on high debt/GDP countries. But the GDP-weighted index should not be mistaken for a neutral benchmark.
Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

Copyright Project Syndicate - www.project-syndicate.org

A credit vigilante arrives at the Fed

February 10, 2013 4:31 pm

by Gavyn Davies


The speech, which is nicely summarised here by Matthew Klein at The Economist, deserves to be read in full by all market participants. (One member of the FOMC told me last week that the speech was “geeky”, but that was intended, and taken, as a high compliment!)

In summary, the speech argues that the credit markets have recently beenreaching for yield”, much as they did prior to the financial crash. Although not yet as dangerous as in the period from 2004-2007, this behaviour is shown by the rapid expansion of the junk bond market, flows into high-yield mutual funds and real estate investment trusts and the duration of bond portfolios held by banks.

Governor Stein suggests (hypothetically) that this may become a policy headache within 18 months and, in a break with the Bernanke/Greenspan doctrine, he indicates that the right weapon to deal with this might well be to raise interest rates, rather than relying solely on regulatory and other prudential policy to control the process. This would obviously come as a big surprise to the markets, which have tended to view the Fed’s stated concerns about the “costs of QE” as so much hot air.

It is clear that the economic staff at the Fed has been doing a great deal of empirical work in identifying financial market bubbles rather earlier than they have managed to do in the past.

The fruits of that work are shown in the empirical benchmarks introduced in the Stein speech. In the past, investors have tended to measure risk appetite by observing risk premia in bonds and equities, and especially credit spreads on corporate debt. These spreads have dropped sharply during the reach for yield in 2011-2012, but they have not yet dropped much below the average levels reached in the decade that preceded the crash, as the first graph shows. This is a common pattern among global credit spreads at present, and it also applies to equities as well.

Why, then, is Governor Stein becoming concerned? One reason is that he is not just worried about spreads, but also about the quantities of investments being made in risky assets. This is illustrated by these graphs taken from his paper:

Governor Stein points out that the quantity of high-yield bonds being issued, or the share of high yield in the total, is an important indicator of future returns on these investments: more high-yield issuance leads to more defaults and lower returns, at any given spread. He also argues that non-price variables, like the degree of subordination in the capital structure, can vary a lot through the cycle, making investments far more risky than they appear at first sight.

Governor Stein believes that the rising shares of high yield in total issuance, and increased amounts of subordination at any given credit spread, suggest that markets are over-reaching for yield, with dangers that a bubble might soon develop. A mitigating factor is that there does not seem to be as much maturity mismatch in credit products as there was before 2008, which makes a sudden implosion from deleveraging and fire sales less likely, but there are some sectors (mentioned above) where a maturity mismatch is already developing.

The conclusion, which seems right to me, is that a credit bubble may already be building, but it has not yet reached a point where it poses a systemic threat to the financial system. In Fed language, that would mean that the “costs” of quantitative easing have not yet risen too far. But Governor Stein is much more worried about this than any of his colleagues (apart from Esther George at Kansas City), and he will be following his new set of dials very carefully. His real concern is that they could be flashing red by 2014.

If so, the FOMC will be faced with a big decision, which is whether to respond to signs of a credit bubble by raising rates (or ending QE) when the rest of the economy points in the other direction. The received wisdom at the Fed is that this should not happen. According to the Bernanke/Greenspan doctrine, interest rates, and balance sheet expansion, should be directed towards inflation and unemployment, while regulation and prudential policy should be used to prevent bubbles in the financial system. (This all stems from a paper written by academics Ben Bernanke and Mark Gertler in 1999.)

We do not know whether Chairman Bernanke continues to believe this, though he defended the proposition as recently as in 2010 and, after all, his current policy is intended to drive investors into risk assets. What we do know is that governor Stein is very doubtful about it. This is what he said last week:

If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior While monetary policy may not be quite the right tool for the job… it gets in all of the cracksChanges in rates may reach into corners of the market that supervision and regulation cannot.
“It gets in all of the cracks” could be a phrase that sticks. It implies the Fed may need to change interest rates to contain a credit bubble, even when economic factors suggest the opposite. Even if Governor Stein is at the hawkish end of the FOMC on the possible need to raise rates, which he likely is at present, the arrival of new regulatory and prudential controls in the next couple of years would, on their own, be enough to truncate the bull market in credit.

The Fed’s new credit vigilante is clearly a man worth watching.