Greed and Fear. “Risk On” and “Risk Off.” “Markets will do what markets will do.” It’s not unreasonable to accept that today’s markets are simply following typical patterns. There’s nothing that remarkable about the current backdrop’s wavering greed and fear – and markets taking on lives of their own. There is, however, something notably different about today’s “risk on/risk off” dynamic.
Changes in structure have altered market function, especially compared to previous crisis periods. First and foremost, the pandemic unleashed unprecedented central bank liquidity. This significantly boosted cash holdings across the system, including those of financial institutions, investment managers, the leveraged speculating community, corporations and households. Spectacular asset price inflation (i.e. stocks and securities, houses, crypto, etc.) enlarged already inflated financial cushions for market operators, corporations and the household sector. For speculators large and small, an enormous pool of the “house’s money” became available for wagering and absorbing losses.
In short, the wild inflation of the world’s major central bank balance sheets significantly expanded private sector assets – from American households’ financial and real estate holdings to emerging market country international reserves.
Especially after the recent market rally, talk of “resilient” has become commonplace and central to the bullish narrative. And this resilience – at home and abroad – is undoubtedly associated with the “buffer” created from Trillions of pandemic QE. The significant tightening of market financial conditions for the most part didn’t spark panic in corporate boardrooms. Household net worth took a hit from sinking stock prices. But the extraordinary inflation in securities and home prices ensures perceived household wealth remains significantly above pre-pandemic levels. And for the vulnerable emerging markets, huge international reserve holdings made “risk off” deleveraging and “hot money” outflows more manageable.
Back to “risk on/risk off.” Central bankers across the global were raising rates. Faced with acute inflation risk, the Fed was especially hawkish. Bubbles were bursting – from Chinese developers and apartments, to global bond markets, to technology stocks and the cryptocurrencies. There was every reason to hedge risk across the markets, and players from major institutions to hedge funds to individual investors flocked to derivatives markets for protection. (more…)