NEW YORK: Financial markets are being hit by a heavy dose of risk aversion, prompting investors to sell stocks, emerging market debt and high-yield bonds. The Japanese yen has surged, unwinding the carry trade. Factors that prompted turbulence in the financial markets since February 26 include a situation that is driven by an overstretched bull market.
Global equities have risen sharply in a rally that began in March 2003. Although there have been setbacks, notably in May last year, stocks have been on a tear. Investors argued that after such a rise, a fall back will be inevitable. Some feel that there are historically no time limits to such rallies and that after a correction there is no reason why it cannot pick up again immediately.
The markets are abuzz with rumours which suggest that investor confidence is being shaken by factors like tension brewing in Iran, apparent slowing down of US economy or rise of hedge funds. Is it a combination of these factors or is any one of these reason enough to create this upheavel?
With ultra-low interest rates in Japan and other countries having encouraged many investors to borrow yen and use the money to invest in high-yielding currencies and their assets elsewhere, borrowers have found themselves in a situtaion where they are highly exposed to interest rate rises in Japan and interest rate pauses or cuts in other countries.
The strengthening of the yen -- around 4% against the dollar over the week, suggests an unwinding of the carry trade. If investors continue to unwind at the same rate, there may just be a currency rout.
There has been talk of the US economy slowing down though what needs to be determined is how slow is the pace and how will it impact the rest of the world. Current market turmoil followed on the heels of some disappointing U.S. data and investors say that U.S. economic vigour is the chief factor driving markets.
The big fear is that the U.S. housing market will continue to contract, leading to pressure on U.S. households and the U.S. financial system from defaulting mortgages. Growing concern about low grade, or “sub-prime”, mortgages in particular was one factor cited for the market shakeout.
While many analysts predict that the U.S. economy will have a so-called soft landing or mild decline, others are projecting something sharper. Likewise, there is a debate about whether other countries’ economies can “de-couple” from the influence of the U.S., that is thrive despite a U.S. cooling.
China may be the new kid on the block as far as economic powerhouses are concerned but its role in the current global economic and investment landscape has ensured that investors are keeping a sharp eye on developments there.
The big fear is that China’s booming economy will overheat and crash, upsetting the delicate balance in world investing in which U.S. consumers buy Chinese goods and China uses the money to invest in U.S. Treasuries, supporting the dollar and keeping U.S. borrowing rates low. It was a nearly 9% fall on China’s stock market on February 26 that at least in part triggered the current market ructions.
The rise of hedge funds, which are often secretive about their investing and which often involve themselves in complicated plays, linking many different asset classes, has raised a number of concerns about their vulnerability to sudden shocks.
As with the carry trade (above), some fears are that markets are highly vulnerable to hedge funds seeking to exit a strategy in a single rush. With leverage as a major modus operandi, there are also fears that one or more hedge fund failures will have a significant ripple effect elsewhere.
Citigroup calculates that February 26 saw the worse 1-day returns for hedge funds since at least 2003 and that macro and market-directional funds lost nearly twice what they did on any one day during last May’s correction.
The bull market has led to extremely low volatility, that is expectations of sharp market moves. This in turn has fuelled a huge demand for risky assets as investors have banked on a limited change of losses.
The fear is that a return to volatility will snowball, battering assets such as low-grade corporate and emerging market debt and riskier stocks.The VIX, a major indicator of volatility, has surged more than 66 percent in a week as expectation of future turmoil in stocks soared.
Tension in Iran has probably led to a standoff between major powers and Iran over the latter’s nuclear programmewhich has focused investor attention on political risk. Oil prices rose above $61 a barrel in part on concerns about Iran, although they have since fallen back a bit. Such rises lead to more worries about slowing economies, rising inflation and a consumer retrenchment.