Macaskill on markets: Trading the Great Moderation

Jon Macaskill
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Summer is upon us and with it the lull of the Second Great Moderation. The First Great Moderation, in the half decade to 2008, was a disappointment, given that it ended with the worst market crisis since the crash of 1929 and a global recession.

But it will clearly be different this time, as the world's central bankers devote themselves to ensuring that any signs of market stress are addressed with soothing commitments to low rates. Gone are the days when key central bankers were either wild-eyed free market acolytes of Ayn Rand (Greenspan, Alan) or owlish old buffers blinking in the sun (King, Mervyn).

Today's technocrats of market stability are an altogether more impressive breed. Even when the debonair new governor of the Bank of England ("the name's Carney, Mark Carney") shoots the sleeves of his immaculately tailored dinner jacket and warns that rates may rise rather earlier than expected, the assembled luminaries of the City of London take comfort from the knowledge that here is a man who knows what is required.

And if Carney has an equal in emollience, it is Mario Draghi of the European Central Bank, with his pledge that he will do whatever it takes to ensure stability. What exactly this might be is never explained, but everyone understands that it will be enough.

This masterful central bankery has had an understandable effect on market measures of volatility, which in turn is creating a dearth of trading opportunities. The Vix measure of S&P stock index volatility, once known as the fear gauge, had subsided almost to 10 by late June and was threatening to touch lows not even plumbed just before the credit crisis.

Across the rates, credit and foreign-exchange markets, other measures of volatility were also reaching or flirting with historical lows. Traders looked back at relatively recent periods that certainly felt volatile, if not downright alarming, such as the euro crisis of 2011/12, and realized that they had been wrong.

While pundits were warning of an imminent break-up of the euro and a retreat to caves for the effete inhabitants of the eurozone, the euro/US dollar exchange rate remained locked in an almost bizarrely narrow range of between 1.31 and 1.34 dollars to the euro, in what now seems like a harbinger of the Zen-like market conditions that are prevailing in 2014.

Pity the former swashbucklers of trading, the bank prop traders and 
hedge fund tyros who once rode waves of volatility to outsized profits, zigging 
when others zagged and bishing when weaker spirits could only bosh

Market commentators are coping with the change to a world of very little change. Pimco has adapted its description of the slow growth period expected after the 2008 crash (the new normal) to coin the phrase the 'new neutral'. 

This streamlined upgrade of an old catchphrase has been joined by the term 'patient capital', to describe the steady hands at certain investment firms who supposedly stand ready to correct any market lurches that might accompany an upward spike in interest rates and accompanying flight by panicking retail bond investors.

This iron willed source of buying in a potential crisis might be needed, given that bankers are now forbidden to reverse imbalances with proprietary trading, or indeed to hold significant debt inventories.

What exactly these patient capitalists do all day as the Second Great Moderation stretches on is a mystery, but it is a great comfort to know that they are waiting in the wings.

Analysts are also using cross asset valuations to demonstrate that what might seem like signs of absurd complacency in some sectors are in fact buying opportunities that have simply not been well understood. Stock analysts at Citi admitted in their half-yearly review of the European equity markets that many stocks did not look cheap, given that there has been a prolonged price rise.

Further reading

Macaskill on markets

But the analysts also highlighted the inexorable rally in the credit markets, where diminished secondary liquidity and a borrower default rate close to zero has encouraged steady buying from fixed income investors with few options in a zero rate world.

Most credit versus equity models show that the credit markets are over-valued, which apparently can only be viewed as a sign to buy stocks, as no-one is expecting an end to the tightening in credit spreads and appetite for new bonds seen so far this year.

Life in this best of all possible investing worlds is clearly sweet for steady-as-you-go holders of assets. But pity the former swashbucklers of trading, the bank prop traders and hedge fund tyros who once rode waves of volatility to outsized profits, zigging when others zagged and bishing when weaker spirits could only bosh.

Some of them may even be wondering whether their former success was due to the privileged information flow and access to under-priced capital that allowed them to make substantial bets in trending markets, rather than innate ability.

They should not be discouraged! For there are still trading opportunities available for the bold, and Euromoney is happy to share some tips for trading your way through this unfortunate period of calm in the markets: