Central Bank Desperation

“In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule.” - Friedrich Nietzsche

Doesn't price movement in recent days feel rather ... insane?

With news today of the global coordinated central bank response to the financial crisis spurring a significant move up in risk assets, it is worth questioning if anything has really changed. On the one hand, the reaction to the move is being perceived as bullish short-term as a means of releasing bank stress. On the other hand, one could make the argument that this is a response to an ever-worsening situation, and that the global coordinated effort is really more an expression of desperation to stop a worldwide panic.

It remains to be seen if anything really has changed in terms of market sentiment, and if today's news has resulted in the end of the “December to Remember Breakdown” scenario I've been laying out since Italy's yields spiked to over 7% (still there as of this writing). A few more days of data would be required to see if the crowd interprets this as a true “risk-on” moment.

Personally, I remain skeptical. Take a look below at the price ratio of the iShares JPM US Emerging Market Bond ETF (EMB) relative to the iShares Treasury Bond 7-10 Year ETF (IEF). As a reminder, a rising price ratio means the numerator/EMB is outperforming (up more/down less) the denominator/IEF. Focus less on the price ratio itself and more on the trend.

Click to enlarge

Think of the trend as a proxy for risk-taking within the bond market. When the price ratio declines it means Treasuries are doing relatively better than sovereign paper, which is effectively a credit widening environment. The opposite is true when the ratio is trending higher. Notice the sharp V-formation that has occurred in November (with the bulk driven by just the last three days). The ratio still remains below its 20 day moving average, only recently touching it in what appears to be a mean reversion move. A good amount of this move can be explained by the big drop in the U.S. dollar, which gives a kicker to dollar denominated asset performance.

The bottom line is that while the improvement has been sudden and very sharp, it is unclear if this is just a sharp bounce or the beginning of a new trend in risk-taking. If the move is real, the above ratio should continue to trend higher and market internals should begin to show sustainable improvement. The next few days will be important – until further confirmation comes in, for all we know this may simply be a one day gift for the bears.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.