Catastrophe Averted In Hong Kong, Italy, UK, Perhaps.
JOHN AUTHERS
If there is anything markets are bad at, it is pricing in low-probability extreme events. We learned that in spades during the credit crisis, and global markets are treating us to another demonstration now.
The dollar has been strong recently – and plainly too strong for the taste of the president. But it had a sharp downward turn Wednesday. In the chart below, the white line is Bloomberg’s broad dollar index, and the blue line is JPMorgan’s emerging market currency index, against which the dollar has been particularly strong:
Why such sudden dollar strength? Not because of anything much that has happened to the U.S. economy. We still have a raft of data, and a lot of Fedspeak, to look forward to before the week is out. And it also had little to do with the bond market, recently at extremes, which enjoyed an unusually quiet day. There is no particularly great reason to think that the long-term perspective is healthy.
However, in three different points of the globe, a small but growing risk of disaster has significantly reduced. First, in Hong Kong, the city’s chief executive has withdrawn the extradition bill that triggered months of protests. This is widely seen as a significant concession that implies the Chinese authorities do not have the appetite for a confrontation at this point.
This in no way resolves the problematic status of Hong Kong or the issues that have been uncovered over the last few weeks. But the nightmarish visions of a repeat of the 1989 Tiananmen Square massacre that had troubled global investors have receded. Nobody can put a good number on how great that probability was before, or how great it is now, but the way the Hang Seng Index rallied on Wednesday shows that a far lower probability of disaster is now being discounted. After seriously lagging the main world stock markets during the disturbances, Hong Kong stocks enjoyed an emphatic recovery:
Then there was further good news from Italy, where an unlikely coalition of the center-left Democratic Party and the populist-left Five Star Movement continues to take shape. This follows more than a year of elevated perceived risk as Five Star made an implausible alliance with the anti-immigration League. A few weeks ago, it seemed that the League was breaking up the coalition and about to seize power. Now, the League appears to have exiled itself, while a much more market-friendly party has entered government. The chances of a head-on confrontation with the EU over fiscal policy have dropped dramatically.
Italy still has a dreadfully sluggish economy, and few tools with which to stimulate it. The only reason the new coalition does not look totally unwieldy is because it is at least a little more coherent than the one it replaces. But with the chance of catastrophe much reduced, the spread of Italian government bond yields over equivalent German bunds has dropped below 1.5 percentage points. It is now at levels typically seen in 2017, before the last election.
Once the spread seemed alarmingly to be heading to the extremes reached during the eurozone’s sovereign debt crisis, before the European Central Bank’s Italian governor famously promised to do “whatever it takes” to save the euro. Now, Italy is much less of a source of anxiety for those trying to put a price on catastrophe risks:
Finally, there is the U.K. The country is in a deep political mess, with no obvious resolution. But the events of the last 48 hours have caused a sharp swing in the perceived probability of the country leaving the EU without a deal – a scenario that investors believe is the single worst outcome to the country’s Brexit debacle.
The chart shows the pound’s exchange rate against the dollar since Boris Johnson, who appears happy to countenance a no-deal exit, took over as prime minister. His premiership has been seen as deeply alarming; and his historic defeat is seen as greatly reassuring:
Political uncertainty is extreme and while Johnson has sustained a defeat he may yet have the last laugh. But the chances of a disaster scenario have plainly just decreased, and so the pound has strengthened. More on Brexit below.
When investors are worried about risk, they tend to shelter in the dollar. And so, with catastrophe risks reduced in Hong Kong, Rome and London, money flowed out of the dollar, and made life a little easier for the U.S. president and his central bank.
Judging low-probability extreme risks is, as I said, notoriously difficult. There is every reason to fear that the market has gone too far in response to some market-friendly news. But everyone is grateful for something to celebrate.
Bloomberg
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