The Six Degrees of Risk Aversion

Market commentators are always talking about risk aversion or risk appetite. I have often questioned whether I use these terms as a cop out because I can't find any other explanation. The answer to my own question is I hope not, which is not very definitive, so let me explain.

Last week on May 13, aptly enough, the markets took on a decidedly morbid tone and I wrote in my morning update that risk aversion had returned, which had benefited the dollar. On this particular day, I thought this needed a little further explanation as there were more moving parts to the news than usual.

It started after the U.S. close on May 12, when the Financial Times of London's first edition had an article alluding to the amount of quantitative easing (QE) being used by the U.S. The Treasury and the Fed were using QE (buying back government bonds) to keep U.S. interest rates down, putting the U.S. country risk rating of AAA in jeopardy.

The effect on the Forex market resulted in the euro jumping from 1.3650 to 1.3725 and the pound went from 1.5265 to 1.5325. If we use the relative ratio of the exchange rates the 75 bps move higher in the euro should have equated to a 1.356:1.5265 *75 move or 84 pips, yet the pound only moved 60 pips! Why? I am getting a little granular with this, but the point is the UK had undertaken considerable quantitative easing itself, so its reaction to the rating change story was directly related to the QE it had also undertaken and was a more muted knee jerk reaction than that of the euro. Judging from the recent views of German Chancellor Angela Merkel and ECB head Trichet, Europe had been reticent to embark on a concerted quantitative easing program.

Next, things changed very rapidly (as they often seem to these days) when the U.S. released the Advanced Retail Sales data, which showed the consumer was not spending as much as had been expected. As such spending is said to account for about 70 percent of the U.S. GDP, the markets took little solace in the previous news and all the "riskier" markets turned south. Stock futures indicated a drop of about 140 points in the Dow and the EUR, GBP and all the other currencies that had gained on the rating story turned and went lower. The riskier market commodities turned around and went lower, even though the energy inventory news indicated there had been a much larger draw down on gasoline and oil inventories than expected. The risk aversion fear was so high it outweighed the inventory news that should have sent oil higher and by the end of the day oil was actually lower by a dollar. (This kind of move is often referred to as a key reversal.) The euro fell over 1.5 cents from its high and the pound fell 2.25 cents. The CRB (commodities) Index fell from 243.58 to 240.82, yet gold - one of the CRB Index components - rose $2.5 from its opening price, another signal of risk aversion. The other CRB Index components - the soft commodities that you and I buy, such as meats, agri products and lumber - were lower.

Bonds, of course, were rallying (yields declining) as the safe haven that attracts funds internationally, as well as from the U.S. Bonds also rallied in Europe and gilts in the UK, due to this flight to safety. The irony is that, as I have mentioned before, this is a U.S. problem (in this case two problems), a potential rating downgrade and poor retail sales, which lead to a stronger dollar as foreign investors buy the U.S. dollar to buy the U.S. government bonds, the same bonds being threatened with the downgrade.

What I am trying to get to here is that there is a tipping point, where the scales go from balanced towards either risk appetite or towards risk aversion. In a case like this, bonds rally, the dollar rallies and normally the yen rallies while all the other currencies, equities and commodities go down. There was one exception in that the Swiss franc typically trades like the yen (a safe haven play), but has flip-flopped recently in such circumstances. On this particular day the fence-sitting CHF followed the euro. To revert to the title of this piece there are about three different scenarios that would tip the scales toward risk appetite and three that would tip the scales toward risk aversion.

Swings like this either hold or fade depending upon the momentum of the initial fear or the return of the happiness factor. As we all know the markets have very short memories until something sets up and appears to be the start of a trend, either higher or lower, and everything else will be dragged along by the flow. The cycle can be fast or slow. Currently it seems to switch almost daily, resulting in highly volatile markets.