Strong forces pulling financial markets in different directions will make the markets volatile. Investors should be cautious.
Readers will recall my alerting them earlier about the possibility of significantly higher volatility in financial markets this year. I even went to the unusual extent of warning investors about the dangers of taking leveraged positions because investment margins are calculated based on past volatility. Although recent developments in options markets indicate that the implied volatility of global equity and bond prices has declined, it should not be assumed that this decline reflects the future risks in these markets. Instead it may have led investors to become more complacent. When actual volatility becomes sharply higher than what is suggested by historical patterns, investors could face serious unanticipated losses.
The reason why I thought volatility was likely to increase is actually quite simple. There is a confluence of unusually strong forces pulling financial markets in different directions. As releases of economic data cause international market sentiment to shift its focus from one aspect to another, there is a tendency for the forces pulling in a particular direction to dominate temporarily and move markets substantially, before the spike is compensated or reversed by other strong forces. Although this is heaven for financial market traders living on short-term volatility, ordinary investors who are less close to the market and may take a relatively longer-term view in their investments are unlikely to benefit from such volatility. Chances are they will be made worse off, particularly if they are highly leveraged.
The most obvious factor weighing on financial markets is the external imbalance, specifically the current account deficit of the United States. At over 6% of GDP, and in the absence of any consensus that the inevitable adjustment will be a benign one, this is a very strong force influencing market sentiment. The unusually large interest rate differentials between the US dollar and the two other major currencies (the euro and yen) have been acting as a counterweight, supporting the US dollar in the foreign exchange market. We are now seeing an interest rate differential between the Japanese yen and US dollar (in favour of the latter) of five percentage points. Yet the yen has recently been appreciating against the US dollar, probably reflecting market sentiment that the interest (opportunity) cost of holding the Japanese yen rather than the US dollar, amounting to five per cent per annum, is not a lot compared with the substantial anticipated short-term gain in the exchange rate.
The movement of the exchange rate of the renminbi, the currency of the economy responsible for much of the growth of the world economy, has also become the focus of much market attention following the introduction of greater flexibility to the exchange rate system last July. Given the capital account controls on the Mainland, a few Asian currencies (fortunately not the Hong Kong dollar) are being used as proxies in taking a possibly speculative position on the renminbi, or as alternatives to holding US dollars. Strong political pressures have also been fuelling such position taking, so has the urge for jurisdictions with substantial current account surpluses to diversify their ever increasing foreign assets.
Meanwhile, the recent historically large surge in oil prices represents another strong force with the potential to influence international financial markets sharply through its effect on inflation and interest rates. While the apparently buoyant global economy is providing considerable support to the stability of the global financial system, as central banks increasingly do not wish to be "behind the curve" in containing inflation or anchoring inflation expectation, and as interest rates continue to rise, albeit at a slower pace, there may be strong reactions in individual economic sectors, in particular the asset markets. The possibility of sharp adjustments and associated adverse effects on consumption and the economy in general cannot be ignored.
Perhaps financial market volatility is something that Hong Kong investors like. Nobody seemed to be too worried about an adjustment of 1,500 points in the Hang Seng Index in two weeks. I hope that this not only reflects the sophistication of investors in Hong Kong, but also their ability to manage risks.
Joseph Yam
25 May 2006
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