The odds on volatility shorten

David Morris

AFTER a strong start to the New Year, equities began to flag at the end of last week. Wednesday’s blow-out ADP employment numbers were largely ignored as investors held off for Friday’s non-farm payrolls. These proved to be a disappointment, despite upward revisions to the two preceding months. Apart from the weak headline number, the unemployment rate dropped unexpectedly to 9.4 per cent from 9.8 per cent. But this improvement looks like it is due to seasonal factors, and discouraged workers leaving the job market. The labour participation rate hit a 25-year low at 64.3 per cent, well below the historical average of 68 per cent.

While most global stock indices ended 2010 with a positive tone, the last few weeks were characterised by low volumes and a focus on higher US Treasury bond yields. So far, equity investors have interpreted the rise in yields as a positive response to a slew of steadily-improving economic data. They have chosen to ignore the uncomfortable fact that the Fed’s last round of quantitative easing was supposed to keep bond yields low.

The trouble is that bond investors are looking ahead beyond June when the current $600bn stimulus is set to end. Without another financial blow-up, such as an escalation in the foreclosure scandal or meltdown in the US municipal bond market, it will be extremely difficult for the Fed to argue for further stimulus. The political and popular opposition is likely to be immense. Bond investors are all too aware that the Fed has overtaken China as the biggest holder of US Treasuries, in addition to its immense exposure to the US housing market through its holdings of mortgage-backed securities. Of course, if there is a genuine recovery in the US, inflation expectations will rise and the Fed will need to remove its stimulus by reducing its balance sheet. That really would put an end to the 30-year bull market in bonds.

In the meantime, the debt crisis in the Eurozone has stepped up a gear. Portugal looks like it will be joining Greece and Ireland in having to ask for a bailout. Add in the US fourth quarter earnings season which is just beginning, and the odds on a pick-up in market volatility have shortened considerably.