Thursday, January 03, 2008
risk appetite index
It turns out that global risk appetite is a pretty good leading indicator of global growth. In addition, Wilmot found that moments of “global euphoria” and “global panic” made intuitive sense (which is apparently more than one can expect from other more traditional proxies of risk aversion). Interestingly, the lowest-ever level of global risk appetite (“panic”) and the second-highest-ever level of global risk appetite (“euphoria”) have both occurred in the past 5 years. In other words, we seem to have all developed a serious bipolar disorder.
Wilmot also observed that panics lasted for shorter periods of time than euphorias and that they tended to be sharper and more extreme. Also, euphorias and panics occur in regular sine waves at a frequency of about 41 months (very similar to the cycle in global industrial production). He presented a chart that shows we are currently at the top of one such wave. And if previous patterns hold, we observe that global risk appetite should be about to fall off a cliff (although Wilmot is very clear that he is not making this prediction).
as it happens, this was just two weeks before the february crisis that brought the word "subprime" into the american popular lexicon. wilmot didn't want to make a prediction, but he should have.
this research from the dallas fed updated wilmot's index through mid-december, but at least as interesting is the longer term picture put forward here by pimco's american credit analyst in november (see below).
this should adequately contextualize my view of where the united states is in its credit cycle -- coming off a tremendous boom, staring down an awful bust. paul mcculley lays out the scenario again, explaining the minsky moment and laying out the path before us:
What both bubbles need to complete the deflation process is what Alan Greenspan calls a “selling climax” — essentially an auction with no reserve prices, in which the huge overhang of unsold and default property is liquidated, as well as the junk mortgage securities of shadow banks (as well as conventional banks).
... My simple point is that the process of deflating bubbles is quicker the more rapid is the deflationary process. It’s also true that the more rapid is the deflationary process, the greater is the pain in the real economy, including sharply elevated risks of a recession.
Thus, policy makers have a tricky balancing act: let the deflationary pain unfold, as it’s the only way to find a bottom of undervalued asset prices from presently overvalued asset prices, while providing sufficient monetary and fiscal policy safety nets to keep the deflationary process from spinning out of control.
bill gross is even blunter.
What we are witnessing is essentially the breakdown of our modern day banking system, a complex of levered lending so hard to understand that Fed Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August. My PIMCO colleague, Paul McCulley, has labeled it the "Shadow Banking System" because it has lain hidden for years—untouched by regulation—yet free to magically and mystically create and then package subprime mortgages into a host of three-letter conduits that only Wall Street wizards could explain.
deflation is fully underway in the united states as the shadow banking system created by securitization collapses and migrates back onto bank balance sheets, constricting credit and forcing liquidation. it remains to be seen if the fed can manage the collapse by cutting short rates and providing liquidity, or if that is simply not possible because of the scale and complexity of unwinding problems which have been building for decades.
i tend to think the latter is likely, and that the capabilities of the federal reserve to manage large-scale credit contractions that result in a fall in aggregate demand are widely overestimated. in the end, i suspect that fall and the corresponding long-term shift to risk aversion will be reflected in the trailing average of wilmot's risk appetite index. it will be something to monitor.