Written by: Simon Derrick | Chief Currency Strategist and Head of BNY Mellon Markets Strategy team, BNY Mellon
Despite escalating tensions in recent weeks, the Korea Composite Stock Price Index (Kospi) is less than 5 per cent off its all-time high and the Korean won continues to trade comfortably within the range it has established against the US dollar since the start of the year. Traditional haven currencies such as the yen and Swiss franc are only just stirring.
This insensitivity to world events has been a common feature of markets over the past 14 years. The annexation of Crimea, for example, in the first quarter of 2014 had only a passing impact on anything but regional markets. Even so, the recent lack of price action on the back of events on and around the Korean peninsula is noteworthy.
So why have markets become so indifferent to geopolitical risk?
One possible argument is that investors have taken Lord Nathan Rothschild’s dictum that “one must buy to the sound of cannons, sell to the sound of trumpets” to heart. However, the evidence is mixed as to whether this has proved a particularly wise long-term investment strategy. The declines seen in the Dow Jones Industrial Average after the US entered both the first and second world wars, the drops seen at the start of the Korean war, the early days of the Cuban missile crisis and in the immediate aftermath of the invasion of Kuwait in 1991, would all suggest caution.
A stronger argument is that this is an example of the phenomenon that Raghuram Rajan helped identify during his time as the chief economist of the International Monetary Fund as “reaching for yield”*. The argument is simple enough: in an environment of low yields investors shift towards riskier investments in search of higher returns. This search for yield often also leads to what appear on the surface to be benign trading conditions as investors use any dip in prices to squeeze as much additional yield as they can out of the market.
As market volatility declines, investors become more convinced that this is a benign environment and therefore become even more willing to use market dips to build positions. Should the low yield environment continue for an extended period of time, then the temptation to take excessive risk will grow.
As a paper published by the Federal Reserve Bank of Richmond in 2013 noted, “the evidence of reaching for yield is hard to come by”. Nevertheless, the pattern of declining volatility in markets matching to periods of ultra-easy monetary policy appears well established since the Federal Open Market Committee under the leadership of Alan Greenspan took its target rate for federal funds down to 1 per cent in 2003.
On the face of it, this might appear a curious explanation for what is happening right now. The Federal Reserve has, after all, raised its target rate three times over the past nine months (following an initial move at the end of 2015). However, it makes more sense when the actions of other major central banks are taken into consideration.
The European Central Bank continues to run the interest rate on its deposit rate at -0.4 per cent and make net asset purchases of €60bn every month. Meanwhile, the Bank of Japan still applies an interest rate of -0.1 per cent to the policy rate balances in current accounts held by financial institutions at the bank, while also purchasing Japanese government bonds. Elsewhere, the Swiss National Bank, Danmarks and the Sveriges Riksbank have equally remarkable policy settings.
Even for the Fed the story appears increasingly dovish, with participants in the Chicago Mercantile Exchange futures markets giving only a slightly over 50 per cent probability that it will have raised rates again by August next year. In short, this remains an environment of ultra-easy monetary policy.
The fact that volatility in global markets has remained so low so far despite the heightened geopolitical uncertainty is probably the truest measure of the strength of the reach for yield at present. No doubt the ECB is considering this as it moves towards reducing its asset purchase programme again along with the Fed as it contemplates beginning to reduce its balance sheet.
However, the concern remains that the apparent desire for yield may have led to investors not fully considering geopolitical risks such as those currently encountered on the Korean peninsula.
* “Has financial development made the world riskier?” National Bureau of economic Research, 2005
Chief Currency Strategist, Head of the BNY Mellon Markets Strategy Team
Simon Derrick is a managing director of BNY Mellon and is head of the BNY Mellon Markets Strategy team. Simon established the team more than 10 years ago, and has guided its development into a preeminent center of excellence within BNY Mellon. His insights and commentaries have made him an indispensable source for financial journalists around the world, and his frequent on-air appearances have made him a fixture on electronic news outlets.