Why "Risk On" Trades Have Suddenly Become Fashionable

The stock market rallied big-time last Wednesday after the Fed and a gaggle of other central banks announced their latest scheme to rig the financial markets. On the surface, the central banks merely promised to cut the cost of borrowing dollars. Beneath the surface, as we explained last week, the central banks committed themselves to subtle forms of money-printing.

The transition mechanisms that will provide all the yummy goodness to the financial markets are called “swap lines.” And even though most investors probably don’t understand exactly what they are or exactly why they are supposed to be such a great thing, the Dow Jones Industrial Average rallied nearly 500 points immediately after the Fed announced them. At the same time, investors dumped their “safe haven” Treasury bonds. Professionals refer to this kind of market action as the “risk-on trade.”

Investors tried to put on even more risk during Thursday’s and Friday’s trading sessions…but they couldn’t seem to keep it on. The Dow jumped 80 points Thursday morning, before ending the day with a small loss. Friday morning, the Blue Chips soared 170 points, but then slumped into losing territory by the close. In other words, “risk on” in the morning, “risk off” in the afternoon.

“Risk on” and “risk off” are, of course, the two newest catch phrases in the CNBC talking-head lexicon. But you editor would like to submit a third catch phrase for consideration — the “risk way on” trade. That trade seems to be the one most folks are putting on these days, but there’s no name for it.

In other words, the investment world is full of pricey assets, denominated in questionable currencies. Sure, stocks are risky. But everyone knows that already. What everyone does not seem to know is that the “risk off” Treasury bonds may be just as risky, if not riskier than stocks. A 10-year obligation of a heavily indebted government feels very “risk on” — especially when that obligation yields a paltry 2% per year and is denominated in a currency the Federal Reserve is actively and unapologetically printing.

If that’s “risk off,” please give us a heaping portion of “risk on”…especially because the Fed’s spiffy new swap lines merely add to the risks. As recent history demonstrates very clearly, the form of central bank intervention tends to produce lots of volatility, but not much else.

Just two months ago, for example, the Federal Reserve and several other central banks announced “coordinated action” to provide US dollar swap lines that would provide “excess liquidity” through the end of the year. US stocks bounced about 3% on the news, but then tumbled about 10% over the ensuing two weeks.

During the 2008 crisis, a series of “coordinated intervention” announcements produced even more dismal results.

NYSE floor trader, Art Cashin, provides an insightful retrospective:

A friend and floor alumnus, Terry Reilly, passed along this review of prior coordinated moves by the central banks on dollar loan swaps and how the markets reacted:

Lehman Bros. collapsed on September 15, 2008. Swap lines were initiated with the Bank of Japan, Bank of Canada and the Bank of England on September 18…[Prior to the announcement], the Dow was at 10,600 and it would rally 700 points during the next two trading days. But it would reverse course and close at 8,450 three weeks later.

On October 13, 2008 the Fed took off the limits on swap lines and the market soared 930 points the next day from 8,451 to close at 9,387. The market would reverse course again and close at 8,175 within two weeks.

Swap lines were extended with the Central Banks of New Zealand, Brazil, Mexico, Korea and Singapore on October 28. The market rallied 1,400 points in just 5 trading days from 8,200 to 9,600 only to find itself at 7,550 within the next month.

The difference in 2011 is that we haven’t had a large systemically important institution fail — yet… Was this response to the crisis done with the knowledge of an impending failure? Did [the central banks] get out in front of a looming large systemic failure that would have been brought on by a lack of liquidity?

“Yes” is the answer, according to the King Report. “It appears that a big European bank got close to failure Tuesday night,” King relates. “European banks, especially French banks, rely heavily on funding in the wholesale money markets. It appears that a major bank was having difficulty funding its immediate liquidity needs. The cavalry was called in.”

Additionally, King speculates, problems here at home may have also spurred the cavalry into action. “Fed concern about Bank of America was probably a prime factor in implementing the latest scheme,” says King. “If BAC had fallen below $5, there could have been an avalanche of selling because some institutions cannot buy or hold a stock that is less than $5 per share. [Editor’s note: BAC hit $5.03 the day before the central bank intervention.] A cascading BAC could have generated an ‘Emperor has no clothes’ moment for BAC. (Buffett would have been chagrined). So it was imperative that someone closed BAC above $5 on Tuesday and that some scheme had to be implemented to drive the price higher on Wednesday.”

So just as expected/hoped, the markets rallied sharply on Wednesday, enabling BAC and a few other troubled financial institutions to live to fight another day. But the fight is far from over…and the troubled financial institutions are unlikely to emerge victorious, no matter how many times the central bank cavalry storms into battle.

As the King Report correctly concludes, “The crisis won’t be solved by cutting rates or by providing even more easy credit. The problem is not liquidity, which is at a record; the problem is solvency…The requisite purge & restructuring has not yet occurred.”

We agree. Prepare for another round of “risk off”…or maybe even “risk way off.”

Eric Fry
for The Daily Reckoning

The Daily Reckoning