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Roger J Kerr points to seven things that just do not add up, seemingly showing that markets seem unable to price risk properly

Roger J Kerr points to seven things that just do not add up, seemingly showing that markets seem unable to price risk properly

 By Roger J Kerr

Standing back from the daily buzz of the markets leads one to think about of a lot of unanswered questions and things that just do not add up in the today’s world of financial/investment markets and economic trends:-

1. The normal convention and way of things is that bonds and equities as investment asset classes move in value/direction opposite (inverse) to one another. Hence, risk and return diversification for investors as they gain on bonds moving up in price (reducing yields) in economic downturns to offset falling equity values (and vice-versa). So much for the theory! Over the last six months US bonds have rallied to lower yields at the same time Wall Street has scaled record new highs. Will it all end in tears when the Federal Reserve finally recognise the building inflation risks and signal the likely timing of US interest rate increases? When that day arrives both bonds and equities will still be moving together, but in the opposite direction i.e. down in value (bond yields higher).

2Excessive liquidity and extremely low volatility in most markets around the place are a potentially lethal cocktail combination as central banks go for economic growth and investors start to lose sight of risk and “reach for any old yield”. As fixed interest markets exhibit signs of euphoria similar to that of 2007 (i.e. credit margins too low), you have to ask the question as to whether the inevitable sentiment reversal and adjustment will be as dramatic as the GFC?

3. Is Federal Reserve Chief, Janet Yellen running the danger of having US monetary policy too loose for too long as increasing inflation rears its head? She seemingly does not trust that the US jobs growth over the last four months is for real. It could be a classic monetary policy blunder and when the markets ultimately recognise that possibility the market reaction will be swift and severe. The Fed wish to avoid a rapid bond sell off like what we saw this time last year, however they might be the ones creating it again!

4. How can Italian Government bonds trade at a market yield below that of the US Treasury bonds? On all sorts of comparative economic and Government fiscal measures it makes no sense at all. Italian Government deficits and debt levels are still in the basket-case category, whereas the US numbers are rapidly improving as the economy grows. Another market shock in Europe cannot be ruled out as such assets are now horribly miss-priced and inevitable adjustment and re-alignment could be messy.

5. How can the Aussie dollar still be appreciating against the USD when the major iron ore and coal miners/exporters are losing money and closing operations due to tumbling commodity prices? The probability of the RBA cutting interest rates again must be increasing as they contemplate sub-par GDP growth for some time to come.

6. When will RBNZ Governor, Graeme Wheeler remember what he said in Hamilton on 7 May and dust off the NZ dollar FX intervention manual because it is now even “more opportune” to sell the Kiwi dollar as the TWI at record highs of 81.60 has diverged further away from economic fundamentals? (i.e. falling forestry and dairy prices). The four criteria for intervention are fulfilled in my book. Inflation will not increase much from a depreciating Kiwi dollar as importers are 12-15 months forward hedged.

7. Why are the RBNZ on track to increase the OCR by 1% (4 x 0.25%) over the course of five months from March to July when earlier signals from them were that interest rate increases in 2014 would be gradual? Immigration numbers and decreases in fixed rate mortgage interest rates caused the earlier and harder push on the monetary brake. However, it could be argued that the success of the RBNZ’s own LVR regulation increased bank competition for a lower number of borrowers and forced the lower lending interest rates. Unintended consequences which our exporters are now paying for through the higher dollar.

I do not have the answers; however the benign market conditions, excessive exuberance and low volatility cannot last for much longer. 

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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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