FED IS STILL FUELLING THE RISK TRADE
JANE FOLEY
RESEARCH DIRECTOR, FOREX.COM
CAUTIOUS expectations for growth in the world’s major economies haave seen market commentators predict that risk appetite will be pared back over the coming months. But despite all this talk, the risk trade suffered only a brief decline following the shock rise in the US unemployment rate to 10.2 per cent in October and the surprisingly strong fall in US consumer confidence.
Admittedly, there was some decline in appetite following Federal Reserve chairman Ben Bernanke’s warning about the headwinds that still face the US economy. With poor economic data unable to cause a reversal of the uptrend in equities, though, it seems that the risk trade is showing few signs of tiredness.
The market’s ability to cast aside weak US economic data depends on the outlook for US interest rates. Weak data is feeding the notion that Fed rates will stay lower for longer and this, it seems, is feeding appetite for risk. The ability of the risk trade to remain undeterred by bad US news underpins the accusation that the Fed is facilitating the risk trade, and the dollar remains a preferred funding currency.
To effectively fund a carry trade, a currency must be both cheap and liquid. At 0.25 per cent, Fed rates are below those of the Bank of England and the European Central Bank. Only the Bank of Japan has lower rates at 0.1 per cent. These low rates in the US and Japan explain why the dollar and the yen are currently serving as funding currencies and why we have seen a inverse correlation between stocks and the US dollar index – funding currencies are sold to fund purchases of more risky assets.
AGGRESSIVE PACE
But how long can the dollar retain its funding currency status? Given the US’s flexible labour market, it is possible that when the Fed does start to hike interest rates it is likely to do so at a more aggressive pace than either the ECB or the Bank of Japan. On this basis, the dollar’s life as a funding currency may well have begun to lose lustre by the middle of next year.
What’s more, higher interest rates also ought to have a detrimental impact on risk appetite. Whether or not higher interest rates will rein back momentum in stocks and other risky assets depends on the relative strength of the global recovery.
But while the dollar may be acting as the preferred funding currency, low interest rates are affecting investment decisions everywhere.
The latest data from the UK’s Investment Management Association (IMA) confirm that investors are moving away from cash into higher yielding assets. In each of the six months to September, private investors in the UK have ploughed more than £2bn into funds. Furthermore, equity fund purchases overtook corporate bond fund purchases in September for the first time since 2007.
DIVERTED FLOWS
So despite continued fears that economic growth rates in the US, UK and the Eurozone will remain below trend for the next couple of years, the lack of return on cash is still spurring savers to take more risk. Bond markets have benefited hugely this year from flows diverted away from cash, but the data from the IMA suggests that equities could be coming back into favour.
Although this year’s healthy recovery in the world’s major stock markets is no guarantee of future performance, it is feasible that these rises could be contributing to the decisions of many savers to increase the amount of risk in their portfolios. (The S&P 500 has rallied 61 per cent in dollar terms from its March low.)
If this is correct, then we should start considering at what stage persistent low rates can be linked with the beginnings of asset price bubbles. The resilience of risk appetite indicates that the dollar could weaken further in the coming months and further jawboning by officials to limit the slide can be expected.
The Eurozone’s effective exchange rate is moving back towards its all time high and with China showing few signs of revaluing its currency, ECB policy-makers have been left with little option but to talk up the dollar. But their all their efforts might be in a vain – another push in euro-US dollar beyond $1.50 remains highly likely.