Abigail with attitude: Volatility, trends and 'Europe-itis'

Abigail Hofman
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So the long awaited and much anticipated correction to global markets finally came to pass. Although, if you had been away for an autumn mini-break, you would have missed all the action.

The S&P500 reached a high of 2014 on September 22, then plunged almost 10% in three weeks before regaining 100 points in less than a week. The wild ride was replicated in the US Treasury market, where yields (which every Wall Street economist had told us were on an upward trajectory) plummeted to 1.6% from 2.6% in a three-week period.

This resurgence of volatility could have been a good opportunity to make money if you had called the trend correctly. However, I’m not sure that many surfed the wave adroitly. These difficult weeks have highlighted some of the key trends that affect markets and the banking industry.

Firstly, due to the Volcker rule and other regulatory restrictions, there seems to be a lack of market-making liquidity. No one steps in to take the opposite side of a trade. This could prove disastrous if you have a stampede out of credit bonds, where liquidity is already limited.

Secondly, central banks have kept rates too low for too long. How many times in the last year have we heard that the Fed and the Bank of England are going to stop asset purchases and start raising rates? Yet, as soon as the markets sell off in preparation for such tightening, the authorities scramble to make soothing noises and insist that the money spiggots will remain open.

How can this end well? There is never going to be a good time for the central banks to tighten rates. Yet until they show that they are serious, all sorts of market participants are being encouraged to go on a borrowing binge. Apparently, margin borrowing in the US markets is back to levels last seen in 2007. Some have blamed the recent violent swings in asset prices on the ‘margin clerks’: forcing clients, playing with borrowed money, to sell positions as prices dropped rapidly.

Furthermore, I am once again sensing a new wave of ‘Europe-itis’ as investors and commentators go cold on the continent. For the first time in a long while, I heard talk of the break-up of the euro when a highly respected fund manager claimed the northern and southern countries simply would not be able to co-habit for much longer.

The spectre of a German recession is no longer fanciful. Periphery bond yields are once more a topic of conversation. A senior European banker confided that he thought the markets would test Draghi’s insistence, in his famous July 2012 speech, that the ECB would ‘do whatever it takes’ to support the euro. Senior banker thought the battlefield would be the Greek bond market.

This column believes in Mario Draghi. He is a wily old fox. After all, the man was director general of the Italian Treasury for 10 years from 1991. This was a period when the Italians were borrowing prolifically, and at high interest rates, yet they were widely regarded as one of the most sophisticated and respected borrowers in the debt markets. The phase ‘smoke and mirrors’ comes to mind.