Sober Look: Risk aversion the lowest in over two years

Not surprising after the Fed QE3 announcement. The Fed definitely wants the markets to take on more risk – that is the point! Please read the full analysis at Sober Look. I’ll just skip to the very end, the CITI risk indicator:

(…) Given these subtleties in the risk indicators related to emerging markets equities, lets take a look at a third measure, the Citi Macro Risk Index, to ‘break the tie’. Here is the definition: 

The Citi Macro Risk Index measures risk aversion in global financial markets. It is an equally weighted index of emerging market sovereign spreads, US credit spreads, US swap spreads and implied FX, equity and swap rate volatility. The index is expressed in a rolling historical percentile and ranges between 0 (low risk aversion) and 1 (high risk aversion).

This measure is based on credit spreads and implied volatility indicators. Note that the index is inverted relative to the two above, indicating the perceived level of risk in the markets rather than the risk appetite.

Citi Macro Risk Index (Bloomberg)

Based on this third risk measure, the perception of risk in the system is now the lowest since early 2010, before the Greek sovereign debt issue first moved the markets in a material way.

Other than the underperformance of emerging markets equities, the overall risk aversion seems to be declining toward multi-year lows. Welcome to the new ‘new normal’, where central banks set the level of risk appetite – and right now they simply want risk to be ignored (see discussion).

The related discussion is on the Fed implicitly selling volatility. I’ve not figured out what this means to the investor:

 Fed’s selling volatility into the market will force mispricing of risk: “Credit Suisse has made an important point with respect to the Fed’s purchases of MBS. As we know, a mortgage borrower is long an option to prepay. That means a mortgage lender is short this same prepayment option. Therefore a buyer of MBS is an options seller and the Fed is in effect selling vol into the market.

CS: – It is important, in our view, that the Fed continue to sell volatility – explicitly or implicitly – into the markets. This is at the heart of its quest to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk) to the public. Extending the rate guidance to ‘mid 2015’ represents an implicit sale of volatility – the Fed is giving up the option to hike (arguments about the Fed’s ability to renege notwithstanding).

(Via Sober Look.)

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