Balancing Risk-on Risk-off Strategies for 1Q13

  • Heightened policy uncertainty, recession in Europe, and the Fed’s recommitment to longer-duration treasuries flattened the yield curve in 2012. Now, with markets in risk-off mode and Fed rates at historic lows, the slope has started to edge up.

  • Monetary policy accommodation and strong corporate finances have led to a low volatility environment, with easing corporate spreads and implied market volatility.

  • Although currently a low-risk concern, high money stock levels (M1) and increasing money velocity in a low-to-moderate growth environment could cause unwanted inflationary pressure.

  • The Fed’s concentrated efforts to lower the long-end of the yield curve could be disrupted if ongoing fiscal mismanagement increases economic uncertainty and thus the risk premium associated with long-term U.S. debt.


Bottom line: Economic fundamentals improve with greater Fed clarity

Successive steps by the Fed to clarify that accommodative monetary policy will persist for a prolonged period – additional quantitative easing and explicit unemployment rate and inflation targets – has assuaged market concerns that the end of QE3 is around the corner. The stronger commitment appears to have aided financial markets’ willingness to search for higher-yielding financial products. Reduced federal austerity and policy uncertainty, along with strengthening consumer demand, have also reinforced the Fed’s efforts to lower aggregate uncertainty. The riskoff environment, exemplified by the pre-recessionary levels of implied market volatility (VIX) and corporate spreads, may not reflect actual market risk given that Europe remains in recession, fiscal issues in the U.S. are unresolved, and the sustainability of U.S. growth is still in question.

Ultimately, lower market risk perception did not translate into sustainable economic improvements. An unemployment rate of 7.9% remains 1.4pp above the explicit Fed target, and our baseline scenario assumes the unemployment rate will remain above the quantitative threshold through 2014. Moreover, near-term inflationary concerns are muted, and the level of fiscal austerity is still highly uncertain. While there are upside risks to long-term yields associated with the credibility of U.S. debt and fiscal uncertainty, we ultimately believe risks are balanced and that the Fed will continue to provide high levels of accommodation for the foreseeable future.