Asset management

16 April 2012

Economist Insights Noise nuisance

Despite no significant changes in the macro outlook, the last few weeks have been characterized by a relatively high level of market volatility. Part of these market movements can be linked to the fading of the ECB LTRO effects. The rest was caused by market noises related to US labour market data, Chinese GDP and fears around the new Spanish budget. Even taken together, these factors do not justify a structural shift in market sentiment. However, when the volumes being traded are low and markets are looking for new direction, it is not unusual that market participants seize on any noise and overinterpret it as news. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

The last few weeks have seen a lot of movement in markets, with risk rallying sharply and then selling off just as sharply (see chart 1). If you had been on holiday for those weeks you would now find many assets, for example US treasuries, back where they started. You would have wondered what caused all the noise and why it was such a nuisance. Three factors have been making the noise: Spains budget; the US labour market; and Chinese growth data.
Chart 1: Risk sharing Weighted average bond yield in Italy, Spain, Portugal and Ireland, and MSCI G7 equity index (comparative movements) 7.5 7.0 6.5 6.0 5.5 5.0 Dec-11 Jan-12 Feb-12 Periphery bond yields (lhs)
Source: Bloomberg

for example, sovereign bond yields in Italy fell from over 7% in December to below 5% just three months later. This pattern, however, is all too familiar to the markets. The last two years have been a pattern of crisis leading to policy response, followed by a period of calm before something triggers another crisis. The markets have spotted the pattern by now, so they could be forgiven for actively looking for the next crisis trigger. And sure enough, Spain stepped right into the markets sights with its recent budget announcement. To date, the market has been fairly forgiving of Spain. Portugal, Greece and Ireland have always been considered in a class apart, and for a time Spain was seen as somewhat safer than Italy. A low starting level of debt had helped to reassure investors that Spain had sufficient time to deal with its problems. This all changed once the Spanish government announced that it was unilaterally increasing its deficit target for this year. This sounded far too much like the unpleasant experiences with Greece for anyones comfort. In fact, the adjustment in Spains budget deficit target has negligible impact on its debt sustainability. The target for next year remains the same and this years change mostly reflects a downgrading of the optimistic forecast for a mild expansion to a more realistic expectation of a fairly sharp contraction. It did not help that the announcement was poorly handled, coming as it did as a surprise to the other Eurozone countries. Belatedly, Spain agreed a somewhat tighter budget, but by then the markets had scented weakness, and started looking for more. The talk was soon about the ongoing risks to Spanish savings banks and the

1,200 1,150 1,100 1,050 1,000 950

Mar-12 Apr-12 MSCI G7 equities (rhs)

The ECBs long-term refinancing operations (LTROs) were quite simply a massive injection of liquidity into the system. The cash appeared to work wonders for the European crisis

inability of the federal government to control spending in the regional governments. However, this was not new news. An alternative, or perhaps supporting, explanation could be that the original sugar rush from the LTRO cash could be wearing off. As our colleague Curt Custard has described [see Current Perspectives: Sugar High], the flood of extra LTRO cash could easily make markets overconfident. As this cash was put to work buying peripheral bonds and other risk assets, Spanish bond yields would have rallied. Once the flow eases, investors start to question the fundamentals again. It is possible that riskier assets like Spanish sovereign debt had rallied too far and that some of this is simply the correction. The ECB complicated matters somewhat by reminding the markets that it could still use the Securities Market Programme (SMP) to buy Spanish debt if necessary. To put it another way, the ECB is probably quite happy with somewhat higher yields in order to keep pressure on national politicians, but would be willing to step in to prevent any disorderly sell off. The second nuisance to markets was the US labour market report. Investors had become increasingly optimistic about the US economy based on a succession of strong jobs reports, but were disappointed by the data for March, sending US bond yields right back to where they were before the optimism set in. It turns out that markets may in fact have been getting excited about the weather. The jobs reports for January and February benefited from unseasonably warm weather, which brings activity forward and usually results in payback further down the line. Most of the upside and then downside surprise occurred in states where the weather was the most unseasonable. It is likely that trend jobs growth was solid but not spectacular through all three months. Measures of people making initial claims for unemployment insurance in the US were also revised up for recent months (see chart 2), which fits well with this story. Labour market weakness also fits well with Federal Reserve Chairman Bernankes story. In a recent speech, he pointed out that jobs had been growing faster than the indicators for economic activity would normally justify. While Chairman Bernanke admitted activity could be revised up, it turns out he was right when he thought it more likely that employment

would slow down instead. Quite clearly none of this noise is a surprise to the Fed, so it probably has not changed its view on the need for a third round of quantitative easing (QE3). After all, if it had accurately forecast this path for the economy and decided it did not justify additional easing, what has changed? Only the markets perception of QE3 has changed from very unlikely before the labour market report to almost certain afterwards.
Chart 2: Recent jobless claims revised upwards Actual and latest reading of the US initial jobless claims 440 420 400 380 360 340 Jul-11 Latest

Oct-11 Actual

Jan-12

Apr-12

Source: US Department of Labor

Finally, more noise came this week with Chinas GDP growth coming in quite a bit lower than expected. The data was not disastrous, and is quite consistent with a fairly controlled soft landing (if the next quarter does not show further deterioration). In the event, markets did not react massively, perhaps because risk assets had already sold off on the earlier noise. A recurring theme of the past couple of months has been that the market is looking for direction, seizing on any noise and over-interpreting it as news. The volumes being traded are low so you do not need many buyers or sellers to make prices swing around a lot. Until markets can find a clear direction the slightest noise is likely to be a big nuisance.

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