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What have we been up to


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Risk – where art thou?

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I recently spoke to a friend I know from my university days who now works in the hedge fund industry. When I asked him how he was, he responded that as long as the stock market kept going up he was happy. He then added: “For you risk guys, things must be pretty boring.” Well, good for him, bad for us, I guess. Or maybe not.

I appreciate that if you are mostly concerned about stock index tickers flashing green instead of red and hence take the VIX volatility index as the key gauge for risk, then you might be led to believe that it is pretty much smooth sailing at the moment. The VIX, which represents the volatility implied by options on the S&P 500, had been stuck at eerily low levels for a pretty long time, although it has ticked upwards recently. I know a few folks who thought it would be a good idea to go long VIX via some ETF and I am pretty sure it doesn’t look very pretty in their portfolio breakdown.

So is it a risky world out there and if so, what are the current key risks to watch out for? The first part to that question is a resounding “yes”, although I will admit that asking a hedging advisor whether one should worry about financial market risks is a bit like asking a hairdresser whether you need a haircut.

Let us start with the elephant in the room: The French election. The first round is on April 23, the second on May 7. The race between the top contenders is too close to call and the fact that two of them have more or less promised to lead France out of the Euro, namely Marine Le Pen from the Front National and Jean-Luc Mélenchon from the Front de Gauche, has markets worried.

The spread between 10yr OATs and 10yr Bunds, i.e. France’s and Germany’s long-dated government bonds, has been trending upwards since the end of March and is approaching the recent highs just shy of 80bps from February again. This is still a decent way off the 1.30% difference one saw back in 2012 when the Eurocrisis flared up last, and reflects the consensus view – or hope (?) – that neither Le Pen nor Mélenchon will become President as they would lose to either Macron or Fillon in the stand-off (Macron vs. Le Pen looking like the most likely duel according to polls). Should the consensus be wrong, as it has been with Brexit and Trump, then even a yield difference of 1.30% between France’s and Germany’s long-term obligations looks like a very optimistic estimate.

Currency traders are also clearly pricing in the potential fallout from a Le Pen or Mélenchon victory as evidenced by, for example, the so-called 'risk-reversal' in the EUR/USD option market. The “risk-reversal” is a concept describing the relative cost difference between EUR puts and EUR calls. If one looks at options expiring on, say, the 10 of May, then one will find that protecting against a weaker EUR is notably more expensive than insuring against the opposite direction. For example, the volatility, i.e. the riskiness, priced into a EUR put with a strike 2.5% below the current forward rate, is about 4.4 percentage points higher than that for a comparable EUR call (16.9% vs. 12.5%). In monetary terms this means that protecting EUR 1m against a 2.5% depreciation will cost c. EUR 11k more than protection against a strengthening of the common currency of the same magnitude.

The bottom line: Currency option traders are worried that a Le Pen/Mélenchon victory will send EURUSD towards or even below parity.

It is safe to assume that the repercussions of such an outcome of the French election would not be limited to bond and currency markets. I certainly wouldn’t expect stock markets to hold up as well as they currently do. The interesting question is what would happen to interest rates? Surely, the ECB and its peers would take emergency measures and do their outmost to calm markets. However, one needs to bear in mind that the French saying 'Au revoir!' to the European Union would in all likelihood precipitate a financial crisis and put Europe’s banking sector under severe stress. As a result, interbank rates would possibly diverge from the ECB’s repo rate which already happened in 2011 when the difference between the central bank rate and 1-month Euribor widened to 0.70%.

Having portrayed doom and gloom in the last three paragraphs, let us briefly talk about the road ahead in the still more likely event that the French electorate does not vote for either Le Pen or Mélenchon.

Obviously, currency risk won’t go away. President Trump was reported to think that the dollar was getting too strong (whatever that is going to mean) and Britain’s Prime Minister, Theresa May, reminded us yesterday that the pound can also go up as it gained about 2.2% versus the dollar and c. 1.4% vis-à-vis the euro.

And then there is this wildcard called interest rates. Swap rates have been on a bumpy ride for the past six months. Following the US election and some signs of life in the Eurozone, markets got very excited about this whole 'reflation' theme and the 5-year EUR swap rate went up from slightly above -0.17% to about 0.32% in March. The euphoria has calmed down since as the 5-year rate has dropped to about 0.13% again, but inflation seems to be picking up across the board (Italy being an exception) which makes one wonder how justified this lower for longer mantra really is. We will hopefully know more by the end of this month when the next ECB rates announcement is due.

So yes, it is a risky world out there and it will remain so, courtesy of politicians and central bankers. And while risk consultants like ourselves do benefit from a volatile environment, I’d prefer to not see Le Pen or Mélenchon chant “Victoire!” on the eve of the 7 of May.

All views expressed here are the author’s own and are based on information available at the time of writing.





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