A Return to ‘Risk-Off’

The sentiment that some form of correction was overdue came true during the market observation period amid mounting geopolitical concerns.
A Return to ‘Risk-Off’
Rahul Vaidyanath

Complacency has been a buzzword of sorts given a low-volatility environment with stock markets reaching record levels. But the sentiment that some form of correction was overdue came true during the market observation period amid mounting geopolitical concerns and a U.S. Federal Reserve that’s running out of reasons to keep rates near zero. 

This is the classic “risk-off” sentiment, where the money flows from higher-yielding assets into perceived safe assets such as high-quality bonds and the U.S. dollar.

The period began on the heels of the U.S. Federal Open Market Committee (FOMC) meeting with the Dow Jones Industrial Average, S&P 500, and TSX all falling roughly 2.0 percent. A variety of reasons drove the selloff, with the principal one being the perception that the Fed will raise rates sooner and more quickly despite Fed chair Janet Yellen’s dovish tones. 

Not to attribute too much importance to one data point, but the second-quarter employment cost index (ECI) on July 31 in the U.S. came in stronger than expected at 0.7 percent, meaning the cost of labor (wages) rose faster than expected. This could spur consumer spending and give a further boost to an already-improving U.S. economy, and result in the Fed starting to raise rates sooner and more quickly. 

Perhaps the phrase “underutilization of labor resources” from the Fed’s July 30 FOMC statement won’t be the right characterization going forward.

In addition, ongoing geopolitical concerns (economic sanctions affecting Europe, Russia’s apparent troop build on Ukraine’s border, the Israel/Palestine conflict, fighting in Iraq), not to mention Argentina defaulting on its debt again and the recapitalization of Portugal’s Banco Espirito Santo, all added to the negative “risk-off” tone and jittery market. The Chicago Board Options Exchange (CBOE) Volatility Index (VIX), taken to represent a measure of market risk / investor fear in the markets, rose to 16.37 (up 23 percent). 

Bonds Rally

The U.S. 10-year note yield was dragged lower sharply after the U.S. Department of Labor’s non-farm payrolls report on Aug. 1 showed a lower-than-expected 209K increase in jobs and an uptick to 6.2 percent in the unemployment rate. But still, the number is not a bad one as it is symptomatic of a still-healing labor market—not one that is getting worse.

Domestically in Canada, the one tidbit of economic data was a solid May GDP rise of 0.4 percent, a fifth consecutive monthly increase, causing economic growth forecasts for the second quarter to be revised higher. 

But this bit of positive news, which is not typically a big market-mover, took a back seat to the aforementioned factors. Canadian bond yields fell (prices rose), although not as much as the yields and prices of their U.S. counterparts. 

On Aug. 6, the German bund 10-year yield reached a record low of 1.10 percent after June industrial orders fell at the steepest pace since late 2011. Germany, the driver of Eurozone growth, is being affected economically by the crisis in Ukraine, which is causing consumers to rein in spending and businesses to rethink capital investment plans. The euro hit a nine-month low of $1.331 on Aug. 6, according to Reuters.

Looking to the next period, central banks are back in the spotlight, with the European Central Bank, Bank of England, and Bank of Japan having their respective monetary policy meetings. 

Friday, Aug. 8, is a big day for Canadian economic data with the July employment report being released.

However, the situation between Russia and Ukraine will need to be closely monitored, since it is critical how economic sanctions may affect growth and inflation in the Eurozone. 

It would seem as though the equity markets’ shrugging off of geopolitical concerns can’t last forever. The U.S. seems to be the only major growing economy, but the sentiment could be changing with some high-profile mergers and acquisitions transactions being pulled for the time being as fear is back and market participants lose their complacency. 

In Canada, markets are largely at the mercy of international currents while the economic situation slowly improves.

Changes in Key Financial Market Variables

Cdn 2yr yield1.11%1.08%-0.03
Cdn 5yr yield1.53%1.46%-0.07
Cdn 10yr yield2.16%2.10%-0.06
S&P 5001,970.071,920.24-2.5%
US 2yr yield0.56%0.46%-0.10
US 5yr yield1.76%1.64%-0.12
US 10yr yield2.55%2.47%-0.08
Rahul Vaidyanath is a journalist with The Epoch Times in Ottawa. His areas of expertise include the economy, financial markets, China, and national defence and security. He has worked for the Bank of Canada, Canada Mortgage and Housing Corp., and investment banks in Toronto, New York, and Los Angeles.
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