Forget the “great rotation” – this is the “great risk normalization”

By:
Duncan Kerr
Published on:

Much has already been written about the speed at which money is flowing out of bonds into equities, but for some economists this isn’t merely a cyclical phenomenon but a structural shift and potentially the greatest of modern times.

Erik Nielsen, global chief economist for UniCredit, argues that the “great risk normalization” process increasingly “resembles a tsunami of money” that will only increase in magnitude and speed as time rolls on.

“The odds are that we are now witnessing possibly the greatest migration of money from ‘safe havens’ to a more proper risk allocation seen in modern history. (I use ‘migration’ rather than ‘rotation’ because the shift is not cyclical, but structural.)”, Nielsen says in a note.

He adds there is still about $2.5 trillion being burned in excess reserves held by banks in the major central banks and probably close to the same amount in “excess holding” of other virtually non-yielding government securities, such as bunds and treasuries.

“While there has been a bit of movement here, the real yield on 10-year bunds remains at its lowest level since the break-up of Bretton Woods some 40 years ago,” says Nielsen. “And while UK fund managers seem well ahead of their continental colleagues in appreciating the new environment ... a stunning 54% of UK equity funds have underperformed the index year-to-date, according to Morningstar.”

Such is the momentum behind this “tsunami”, Nielsen says it has already crashed through obstacles which would have caused volatility in more normal times, such as “ mind-boggling US fiscal governance disfunctionalities, uncertainties in the Italian election campaign, a bad (if isolated and apparently contained) surprise at Monte dei Paschi, Cypriot requests for help with a lukewarm German reception, and derailed policies in Hungary and Ukraine.”

However, he warns that there are three issues that could have the force to actually stop the flow of money: first, an “unknown” shock; second, an abortion of the global growth recovery; and third, earlier than expected central bank exits.

On the first, Nielsen says he is not going to try to predict what the “unknown shock” could be and says he’s “not very worried” about abortive global growth as this “past week provided the latest batch of beautiful macro numbers out of China and the eurozone as well as pretty decent ones from the US.”

He has this to say on central bank exits, however: “It is important to distinguish between central banks. My bottom line is that there’ll be no meaningful exit this year, but the relative noise levels may well indicate that the ECB will move earlier than the Federal Reserve and the Bank of England (while the Bank of Japan will move the other way next year), which may well strengthen the euro against the dollar and sterling, and weaken the yen (as well as the Swiss franc as a safe haven becomes less necessary).”

Importantly, in the eurozone, Nielsen argues that the speed of the exit will be determined predominantly by the banks, as they decide when to return money to the ECB. The ECB recently said that on the first possible day of returning LTRO money, 278 banks will repay €137 billion, although that is expected to rise to €200 billion. In turn, Nielsen argues this will drive Euribor up by about 25bp.

In the UK, however, Nielsen says it feels like the Bank of England is winding down quantitative easing, while the US Federal Reserve looks likely to end its QE towards the end of this year and then “it’ll be a question of how much it reinvests in 2014 – and the Bank of Japan will start its new wave of QE next year.”

In other words, “there is no likely exit in 2013 apart from what the eurozone banks voluntarily hand back to the ECB,’ says Nielsen.

That may be so, but investors are, as a result, increasingly concerned about such inactivity stoking inflation and/or asset price bubbles. For Nielsen, “the short answer is this is extremely unlikely, but the road to the exit is likely to be bumpy.”