Is risk appetite waning?


We look at three charts which show that the long period of calm in the financial markets may be under threat. 

 

Tranquillity was the defining feature of financial markets in 2017.  Equity markets were buoyant, fixed income markets began to ‘normalize’ (at least in the US), and currency volatility was subdued.  Conventional wisdom is that these ‘goldilocks’ conditions will remain in situ for 2018, before things start to go awry in 2019…however, there are some signs that this view may be a little optimistic. 

 

Equity Markets

Last week, US stocks suffered their largest weekly drop in two years, culminating in Friday’s 666 drop in the Dow.  This move has been mirrored in Europe this morning:

 

Chart I: Euro Stoxx 50

 

We have been here before; equity markets also sold off in 2016 (the S&P, for example, declined by 10% at one point), so it is entirely possible that we are just experiencing a pause in the market before the resumption of the upward trend.  However, as monetary conditions begin to tighten around the world, we may at last be nearing the end of one the longest bull markets in history. 

 

Bitcoin

Perhaps nothing symbolizes the recent state of the markets better than bitcoin.  After starting 2017 at a price of less than $1,000, it rallied by over 1300% to end the year around the $15,000 mark.  The reasons for this incredible rally are very hard to discern (most people would struggle to even describe what a bitcoin is, let alone assign any kind of intrinsic value to one) but it is highly likely that ultra-loose monetary conditions played a role in the bitcoin bubble (and, yes, it is a bubble).

 

Chart II: Bitcoin

So, Bitcoin’s precipitous fall in 2018 is worth paying attention to.  Not necessarily as a systemic risk in and of itself (the total market cap of Bitcoin is large, close to half a trillion at its peak, but it is quite highly concentrated – about 1000 accounts hold about 40% of the world’s bitcoin – meaning that risk of contagion is low) but rather as a ‘canary in the coal mine’, signalling a potentially important shift in market psychology.   

Market Volatility

Ultra-low volatility across asset classes has been another feature of financial markets in recent times.  Subdued volatility is not just a symptom of current market conditions however (like Bitcoin); it is also a cause of market fragility.  Lower volatility means increased (and leveraged) speculation, as investors lose their fear, become complacent and begin building up excessive risk positions (financed with debt) which are increasingly susceptible to market corrections.  As such, the recent uptick in market volatility must be watched very closely.

 

 

Chart III: Equity Market Volatility (VIX) (Black) and FX Volatility (Deutsche Bank FX Volatility Index) (Blue):

To be clear, it is far too early to conclude that a significant change in market conditions is underway.  Our base case remains that 2018 will largely represent a continuation of benign market conditions.  However, the odds that we are entering a true correction are beginning to increase, and this would have a profound impact on currency markets, with the USD being the most likely beneficiary. 

 

Author: Kevin Lester

 

 

 

 

 

 

 

 



 

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