A recent research report by Calyon û The DevilÆs Advocate: Is volatility back to stay? û weighs up these two points of view and tries to pick out where, between the two positions, the truth most likely lies and what the consequences will be for the foreign exchange market.
Pessimists point to a vicious circle that could spin out of control: the falling value of toxic subprime assets will trigger the sale of healthy assets to meet margin calls, which will cause asset prices to fall across the board, which will reduce the value of loan collateral, leading to more margin calls, which will create more forced sellers of assets, leading to further falls in asset prices, and so on to the bottom of the barrel.
This is the contagion nightmare, where the subprime problem spreads even to funds with no risky mortgage assets and then, inevitably, to banks. Meanwhile, central banks are asleep at the wheel, say the doom-mongers. When they wake up it will be too late to prevent a full-blown recession.
In answer, optimists point to strong global growth, high corporate profits, cheap share prices and a welcome re-pricing of risk. Liquidity is relatively tighter but there are still plenty of buyers in the global economy and risk aversion is still at historically low levels.
CalyonÆs best guess is closer to the optimistic side of things. ôThis is not a hiccup, the environment has changed,ö says Daragh Mahar, CalyonÆs senior forex strategist. The crisis will not be sufficiently deep to provoke central banks into easing policy, but a return to normal levels of volatility will ôchange markets in a lasting wayö.
In the period before the spike, rich asset valuations and leveraged positions, says Mahar, had helped to make markets overly sensitive. ôEquity markets may not have been rich,ö he says, pointing to record-low price-earnings ratios on the S&P 500 and good earnings yields compared to bonds. ôBut many other risk assets were. Carry trades in particular were at stretched levels. They still are!ö
Investors shrugged off the London bombings on July 7 2005 without a care, but the combination of extreme valuations and extreme positions means investors today are easily spooked into a collective panic attack, as evidenced by the three bouts of turmoil since last summer.
At the same time, falling asset prices are changing the relationship between borrowers and lenders. ôCredit risk is rising from unrealistically low levels,ö says Mahar. ôSo debtors face tougher access to credit and a higher cost of credit.ö And although there is still liquidity in the global economy, it is drying up. All of this points to a prolonged period of more volatility û from the unusually low recent levels to a more normal position.
That could spell the end of the carry trade, as the recent weakening of the New Zealand dollar against the yen amply demonstrates. ôLosing 9% in two weeks rather dents the appeal of the positive carry,ö says Mahar. ôInvestors in carry have been playing capital appreciation as much as the carry itself. Rising volatility means that capital moves can overwhelm the carry on offer.ö
The carry trade might be a victim of the subprime fallout, but it could be good news for the dollar, which suffered when the failing home loans looked to be a problem contained within the US. However, the dollar should regain its position as a safe-haven currency as problems are reported at institutions around the world û from Germany to Australia û and the crisis takes on an increasingly international complexion.
As prolonged volatility makes the carry trades less attractive, the overvaluation of the high-yielding currencies will unwind, which will obviously benefit the victims of the carry: namely, the Swiss franc and the yen. Both currencies, as well as the dollar, also tend to strengthen when equity markets fall.
However, in recognition of how difficult it is to predict where the markets are headed, Calyon cites several warning signs that the situation is deteriorating to the pessimistsÆ view.
The direct subprime issue itself is perhaps the biggest threat. ôStating the obvious perhaps, but clearly our forecast that the current re-pricing and de-leveraging process does not develop into something more sinister could be undone if the fallout in financial markets were to become more pronounced.ö
Central bank rhetoric is also key. So far they have continued to state the importance of the fundamentals over sentiment. A shift in tone could sound the death-knell for the optimists.