Risk On!

It seems I spoke too soon. Yesterday morning I mentioned (again) that there had been a breakdown in risk-on/risk-off correlations, but those correlations promptly reasserted themselves with a proper risk-on day. Global equities rose; AUD, GBP and EUR rose while USD and JPY fell; long-term interest rates were flat to up; gold, oil and industrial metals all rallied. The cause of these moves was discernible in interest-rate futures, with implied rates falling at the short end of the curve — it was Ben Bernanke’s comments on the state of the economy.

Bernanke said that the recent fall in the unemployment rate might be due to a reversal of the unusually large layoffs (given the size of the recession) in 2008-9, and that further falls might require faster economic growth. He took this as an argument for the continuation of accommodative policy, but did not mention any need for further stimulus.

It could be that Bernanke’s objective is to have the market take the FOMC’s 2014 language — which is literally only a statement of the opinion that the economy will be weak enough to warrant exceptionally low rates at least until late 2014, and as such should be contractionary — as a pre-commitment to keep rates low even if the economy recovers, which ought to be stimulative. However, it sounded more like Bernanke was making the continuation of loose monetary policy contingent on the rate of improvement in the labour market, which would be consistent with his comments at his last press conference and with the suggestion of Charles Evans that the future path of policy be made explicitly contingent on specified rates of unemployment and inflation. The 2014 language is perhaps mildly stimulative inasmuch as it signals a certain doveishness — a statement that an economy like the one we have at present is weak enough to keep rates low is a one that a market concerned about an eventual tightening of policy will take well — but the real loosening recently has been Bernanke’s affirmation of the symmetry of the dual mandate and implied willingness to allow inflation to run a little above target when unemployment is so very far above. Having hit on a guidance-based policy response that actually seems to have a properly stimulative effect (unlike the 2013 and then 2014 language and Operation Twist, which were neutral to contractionary), Bernanke seems to be pushing it. That is a good thing.

What broke the risk-on/risk-off correlations was the impression that the improving labour market in the US had made QE3 less likely. And, indeed, I think it has made QE3 less likely. It could still be that the FOMC will announce further QE in the coming months even if the unemployment rate continues to fall, but given the political consequences of such a move and Bernanke’s omission of the subject from his remarks yesterday, it seems more reasonable to think that there is a Bernanke ratchet put option on the unemployment rate (or perhaps a put on its first derivative) — i.e. that QE3 will come if and only if the labour market ceases to improve. That interpretation is consistent with recent market action. With the US economy improving, QE3 becomes less likely, USD becomes less attactive as a funding currency (especially compared to JPY with the BOJ on its current policy settings), risk-on currencies do not necessarily have the support of expected liquidity-driven inflows which means those with deteriorating fundamentals (i.e. AUD, with China’s current weakness) are able to fall even as global equities rise, metals also lack liquidity support and so also struggle on account of the weakness in Asia, and US equities rise on improving profit expectations (I am thinking of this kind of market behaviour as “risk-decoupling”. However, when Bernanke makes doveish comments, QE3 becomes more likely in the event of any deterioration in the US economy, and there is a classic risk-on day. The obvious question to ask is: what has to happen for there to be a risk-off day? The answer: something so bad that equities would fall even in the face of QE3. A proper confrontation with Iran could be such a thing, but that is far from certain to happen. I find it hard to argue, therefore, that US equities will not rise under any circumstances in the coming months. The performance of other assets, meanwhile, should depend on whether we see US weakness (=> risk-on) or US strength (=> risk decoupling).


  • Pending home sales -0.5% d.e. Feb.
  • Eurozone GfK consumer climate 5.9 d.e. and fell.

Coming Up

  • UK CBI realised sales
  • Case-Shiller HPI
  • CB consumer confidence
  • Bernanke speaks
  • German prelim CPI
  • Eurozone M3
  • UK current account
  • UK final GDP