Have the markets become complacent regarding risk? On the face of it, despite great uncertainty over the direction of the US economy, nobody is worried about anything, writes John Authers.
Buoyant equity markets, the Vix index at an all-time low last week, and low volatility in the exchange and credit markets are at odds with the US Treasury bond market, arguably the most sensitive to the economy. It is signalling a sharp slow-down next year.
The yield curve for US Treasury bonds has been inverted for a while – and the inversion has deepened over the past month as stocks have continued to rally. And the Treasuries market has seen sharp swings in recent months, reflecting uncertainty over the direction of the economy.
As the economy slows – either in a ‘Goldilocks’ fashion or a hard landing – default risk will rise. But CDS indices are behaving as though it is falling, with spreads on investment grade debt dropping to historic lows. Similar concerns exist in the foreign exchange markets. An interest rate rise in Japan, or a move by China to diversify its dollar-heavy currency reserves , could hit the US unit and raise bond yields. And the Bank of Japan has already made clear that it is worried about the potential impact of a sudden unwinding of “carry trades” – whereby investors borrow in a low-yielding currency, like the yen, and park it in a high-yielding currency such as the Australian or New Zealand dollar.
The markets currently seem relaxed about risk. But if the US economy moves into a hard landing, this period of calm could turn into excessive volatility.