While the global financial crisis is probably behind us, volatility is still very present in market participants’ mind. Any source of risk – such as the United States double-dip concern in the second half of 2010 – is still regarded as potentially systemic.
Ironically, the prospect of US growth has clearly improved since QE II (the second round of quantitative easing in the US) in November last year, leading to a structural downward shift in global uncertainty. What happens to look more and more like a strengthening recovery in the US is actually reducing global risk, leaving only country/region-specific issues on the table.
More precisely, better growth in the US is likely to make the uncertainty regarding policy normalisation by the US Federal Reserve (Fed) more immediate.
The second generation of quantitative easing by the Fed was implemented by buying treasuries, particularly in the three to seven-year sector, thus contributing to a historically steep yield curve. Such a curve has always been conducive to growth eventually.
Indeed, the horizon of economic and financial decisions is extended by better long-term return and cheaper short-term financing. Hence the risk of a double-dip is remote in such an environment.
The sequence of events goes from a steep curve to growth, and then to the Fed moving away from its loose and heterodox stance. This concentrates the market risk on the five-year segment of the treasury curve.
On top of the usual shift in Fed fund rate expectations, the accumulated buying of treasuries associated with QE II will eventually have to be unwound.
Moreover, in the absence of lending opportunities, commercial banks have piled up treasuries also in the five-year area. Some revival in private lending, as current surveys point to, would lead banks to sell their holdings in treasuries.
As soon as the Fed signals to the market that it is finally pleased with the recovery and ready to move away from its current heterodox policy, banks will start selling their five-year bonds, resulting in a massive write-down in value and subsequent bond market correction. Unexpected losses and broad risk aversion on the back of the perception that excess liquidity is being hastily reduced is thus a material risk for 2011.
What does all this mean for Australian markets? A change in stance by the Fed would have dramatic consequences for assets such as the Australian currency, which has been the ideal instrument for a China-pulled world recovery with ample US-induced world liquidity.
As the US recovery gathers pace, global liquidity will be less abundant and new opportunities will arise away from China-related themes. All this bodes rather poorly for the celebrated Australian dollar.
