What Even Is ‘Risk’ These Days? 

You could argue that the Fed is getting what it wants.

Or at least achieving the near-term goal of keeping financial conditions easy and reinvigorating the bid for risk assets.

I talked at length about this in “Picture Perfect“, and it’s worth updating the following visual, which just shows the breakdown of yields and stocks.

When real yields surge, it’s kryptonite for risk assets, especially to the extent the result is a materially stronger dollar. So, in that regard, driving reals sharply negative is a boon for equities and the accompanying drift higher in breakevens ostensibly suggests the market has some faith in the reflation narrative and/or believes the Fed is committed to the effort to engineer an overshoot.

And yet, as discussed last weekend in “False Dawns And Summer Doldrums“, reals at -85bps don’t exactly scream “confidence” in the recovery. Earlier this month, SocGen’s Subadra Rajappa called it “a dire signal of the market’s expectations for real growth over the long run”. Since then, reals have declined even further.

“The fall in real yields speaks to the challenged growth environment going forward”, Greg Peters, head of multi-sector and strategy at PGIM Fixed Income, told Bloomberg. “What the bond market is telling you is that growth will be sub-par for quite some time”.

This is almost an “in the eye of the beholder”-type situation in terms of whether you want to use it as an excuse to stay long risk (loose financial conditions and a dearth of yield) or get cautious on the dour signal about longer-run growth. One thing’s for sure, gold is benefiting.

Meanwhile, in the spirit of continuing the debate around what it means for portfolio theory when the Fed has effectively instituted a moratorium on bankruptcies for companies that were “healthy” prior to the pandemic, BMO’s Ian Lyngen, Jon Hill, and Benjamin Jeffery note that the signal from the equity risk premium is now somewhat muddled, at least vis-à-vis pre- and post-COVID comparisons.

“On the equity market front, the strong performance of stocks over the past four months has been much deliberated with differing amounts of angst on the rally”, they wrote, in a Friday note, adding that “arguably, the ERP should be substantially higher in the face of impending corporate defaults”.

And yet, in the context of the Fed’s implicit (some would call it explicit) guarantee for investment grade credit and fallen angels, this is an exercise in question-begging. That is, if the Fed’s primary and secondary corporate credit facilities have effectively transformed all IG US issuers into GSEs, then what sense does it make to speak of default risk?

“The Fed’s willingness to directly backstop the corporate capital structure via the PMCCF and SMCCF has recast underlying risk-asset dynamics”, BMO went on to write, in the same Friday note. “As such, equating the ERP pre- and post-COVID is a bit of an apples to oranges comparison”.

What even is “risk” these days?

Read more: Who Cares Where You Are In The Capital Structure If The Fed Doesn’t Allow Bankruptcies?