Thoughts On Risk Appetite
Submitted by Nic Lenoir of ICAP
We had the pleasure of discussing recent economic developments and the Federal Reserve's policies with ICAP's chief economist Louis Crandall. He views the Fed on hold most likely until Q3 2010. Not until the August 2010 meeting does he see more than 50% chance of a change in the target rate. While the first increase may only be 25bps, he believes the Fed means business when they say policy accomodation may need to be removed fast, and sees possibly a second move between 50 and 100 basis points. He also thinks it is unlikely that the Fed will be using reverse repo heavily this year, and will keep the Fed effective low until year-end.
Beyond these policy observations however, one comment struck me in particular. According to him the Fed is watching very carefully risk appetite. Their removal of policy accomodation, whether it is low rates or liquidity facilities, will be driven just as much by a pick up in market risk appetite as by traditional economic indicators such as production and employment. It makes sense to think the Fed is watching the effect on risk appetite and potential asset inflation of the liquidity it is pumping in the system given that it is a just about universal worry that has triggered a lot of animosity towards the US's monetary policy. However what is interesting is to think right now the Fed views risk appetite as subdued. Is it really?
CapEx is still weak, but so is demand, so one can't really expect companies to plan for big expansion plans, especially given that the consumer and many coporations are considered over-levered already. But not just focusing on fundamentals, let's look at the markets: Commodity inventories are huge but prices have recovered massively, China's stock market doubled from the lows even when their capacity utilization is 60%, the Chinese stock market on July 28 traded more volume on the A-Share exchange in terms of notional than exchanges in New York, London, and Tokyo... COMBINED, US equities price in 4% established growth to come, Turkey's CDS is at all time lows when the country shares a border with Iran, Brazil's Bovespa is only 16% off its highs, up almost 4 folds from 2000 highs, and with a president that has not graduated from high school... Is that risk appetite or what??? When Venezuela feels comfortable enough to issue bonds in USD, I'd say risk appetite is pretty good.
I am not criticizing the Fed for trying to re-establish a certain sense of confidence in the economy and the markets before removing accomodative policies, but I fully disagree with what they think is still a lack of risk appetite. With electronic brokerage accounts and ETFs, money can move very fast, and I am not sure that the impacts of it are fully appreciated yet. Maybe the amounts invested in buy-and-hold strategies have not picked up drastically, but has it occured to anyone that given the state of the economy such strategies might be foolish? Money moves so fast into whatever is in fashion that price targets are blown by in days or weeks not years, and when it comes to credit: with defaults looming around every corner and firms like CIT considering bankruptcy after being rescued once already it is hard to ask for spreads to come back down close to all time lows. Here is an idea: maybe nobody will ever want the $1.3Tr worth of securities on the Fed's balance sheet unless housing prices rise 15% a year thereby improving recovery rate and reducing defaults on mortgages... If the Fed wants to go that route they better flood the system with some serious liquidity, because last time I checked real estate does not look like a great buy just yet. The risk may be that a certain form of risk appetite has disappeared and may not be back. There is a lot of money in a few hands that has really high speculative velocity, and on the flip side the average American's 401K is depleted and makes future unfunded retirement funds liabilities a solid issue that may not entice to gamble whatever is left. Average measures of velocity, liquidity, or production, may not tell the whole story.
Good luck trading,