Bernanke put to the test...

It seems that Fed action has failed to convince the market that the worst of the debt crisis is behind us and that it is doing its utmost to fix the problem. Indeed, the volatility index shot back up, short term treasury yields plummeted and stock markets were trading lower. But this only lasted a day which leads one to wonder whether what we are witnessing here are a series of aftershocks that should subside in time or the prelude to yet another major jolt. Considering that there are a large number of investments for which their August performances to date remain unknown and that, as a result, we are likely to face more bad news, it seems prudent to anticipate more turbulence ahead. The Fed's confidence building measures have clearly helped sooth tensions, but it is increasingly perceived as too little too late. Too little because we expect more turbulence in coming weeks and months and too late because three days before all hell broke loose, the Fed stated that it was more preoccupied with inflation than with the sub prime debacle. At present the markets are factoring in a quarter point cut to occur anytime between now and the next Fed meeting on the 18th of September and, with the recent jump in long term treasury yields, seem to believe that Fed policy has shifted away from an inflationary bias.

After the storm...

Thanks to the concerted efforts of central bank cash injections and the Fed's decision to cut its discount window by half a percent, extend loans to as much as a month and make it clear that even sub prime paper would be accepted as collateral, things look like they are going back to normal. The root of the current crises stems from the innovative changes in the way in which debt is created. Over the last decade we have seen an explosion in the issuance of asset backed securities whereby a relatively illiquid market of loans against some type of collateral are pooled together, divided into quality tranches and securitized. This has worked wonders for those who have traditionally had difficulty in obtaining financing. It has also proved beneficial to investors by allowing them to tap into new market segments in a risk controlled manner (given that many borrowers are pooled together and therefore diversified). But these instruments carry a large drawback in the form of a lack of transparency. The investors do not know what percentage of what they hold will default. That might not matter when things are going well. But when you have a problem such as the recent sudden surge in delinquencies in a sub prime market that came about because lenders, who got accustomed to a low interest rate environment, got carried away with their lending, things can very rapidly turn sour. Liquidity dried up almost instantly because the lender did not know if the borrower was exposed to this toxic market. Confidence was also eroded with the collapse of the Bear Stearns hedge funds considering they had very high ratings. It will be interesting to see if this time around the Fed will take any measures to improve transparency.

A meltdown?

The recent global market slide sparked by fears of a looming credit crunch might very well be the first stages of the so called great unwind. Investors were taken by surprise, especially those that were under the impression of being hedged against this very type of loss. It just comes to show that complex derivative strategies don't always perform as expected.
There are signs that we may be entering a protracted slowdown phase for the global economy. We all recognize the beneficial effects of globalization on growth, especially in terms of its disinflationary impact. If we take the recent past as an example, another beneficial effect seems to be longer lasting economic cycles. What use to be 7 to 8 years of expansion before a recession now seems to last in the range of 9 to 10 years. Greater coordination between central banks and a more prudent approach to monetary policy clearly play a role in this.
But there are signs that the party is coming to a close. As yields worldwide continue to rise, the housing woes will continue to deteriorate. Since consumers perceive housing in a similar manner to stocks, this will invariably have a negative impact on the wealth effect in addition to the effect of higher food and energy prices. Eventually, the yield curve may reinvert. That in itself is not enough to suggest a looming recession. For that to happen, we also need to add rapidly deteriorating credit spreads (something that seems to be occurring at the moment).

The volatility factor

The slide in global markets over the last two weeks were precipitated by markedly higher volatility levels which first spiked when Chinese woes sent stocks on a tailspin back in February last. Higher volatility inflate risk premiums (no wonder it figures in the Black and Scholes option pricing model) creating havoc for certain segments of the markets. More volatility can also be a good thing, depending on how you are structured. With a sudden jump in the vix index, one of the first reactions tends to be a general flight to quality and the most recent market turmoil is a perfect example of this. Credit spreads have widened substantially as money has poured out of corporate and high yield bonds towards the safety of treasuries. There is also a move out of riskier emerging market stocks towards those of developed markets. We can add to this the switch from small cap to large cap although part of it is related to the advanced stage of the cycle. Finally, there tends to be sector rotation in favor of defensive industries such as consumer staples or health care during periods of high volatility.