A sudden drop in risk appetite

  • The eruption of US equity market volatility, with global spillover effects, is a delayed reaction to a rather significant increase in bond yields since the second part of August
  • Market-implied inflation expectations didn’t move that much so the rise in long term rates reflects an increase in real yields which in turn is related to strong growth numbers
  • Historically the relationship between weekly changes in yields and stock market performance is weak
  • This implies that one should focus on drivers of investor risk appetite and in particular signs of slower growth

Research shows that the surprise component of economic data releases, i.e. the difference from the consensus forecast, is incorporated in financial asset prices within minutes. However, the relevance of new data goes well beyond this timespan because they allow investors to finetune their assessment of the economic environment. It implies that a significant cumulative change can end up impacting market sentiment even though the short term reaction to news had been negligible. This week saw an example of such a delayed reaction. Since the second half of August, 10 year US treasury yields have risen 32 bp (chart 1). This corresponds to the increase in the inflation-protected treasury yield (TIPS) because market-implied inflation expectations have been stable. Considering the strong data in recent weeks, we can assume that the rise in real yields reflects an increase in expectations for real GDP growth. Everything else being the same, the rise in yields should have been accompanied by a decline in equity prices. In reality the equity market increased on the back of a more upbeat assessment of the earnings outlook and/or a decline in the required risk premium. This week’s market rout would then reflect a sudden drop in investor risk appetite. Possible explanations could be: a change in the attractiveness of an expensive equity market versus treasury bonds which start to offer increasingly appealing inflation-adjusted yields; concern about the trade war (the IMF’s new World Economic Outlook was quite vocal on the risks this entails); an increasing conviction that the Fed would hike more than expected lately. It could also be, quite simply, a delayed reaction to the rise in bond yields.

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