Don't chase the rally in risk

One of the more interesting developments in the capital markets over the past few weeks is the disconnect between bonds, currencies and stocks.

While stocks and currencies have been unabashedly bullish on risk with S&P 500 up more than 12 per cent and EUR/USD gaining more than 600 points over the past month bonds have been flashing red, signalling risk off. One the more remarkable divergences has been between the EUR/USD and the spread in German versus French bonds. 

Typically the spread between German and French bonds is very narrow as both countries enjoy a AAA rating from the credit agencies. However over the past month that spread has widened to a record level of 120 basis points or 1.2 per cent as bond traders are increasingly concerned about the quality of French credit.

There is good reason to worry. The top three French banks carry liabilities on their books that are greater than 150 per cent of France's GDP. In short, if French banks are forced to take massive writeoffs on their portfolios ( some of which are invested into Greek sovereign bonds) they could create systemic risk within the Eurozone financial system that would wreak havoc on all markets across the world. 

Up to now, currencies and stocks have been blithely ignoring this doomsday scenario with traders in both markets assuming that European officials will be able to work out a solution at this weekend EU summit that will provide a credible backstop to the region's credit markets.

Officials are considering all sorts of proposals from expanding the EFSF and allowing it to become a "buyer of last resort" in the European credit markets to creating a special purpose vehicle investment that would invite private investors such as sovereign wealth funds from Middle East and China to buy distressed credit securities in order to stabilize the markets. 

It remains to be seen if any of these proposals will be successful. For now the bulls have been clearly getting the benefit of the doubt and they have been helped by surprisingly strong economic data over the past few weeks.

The bullish argument rests on the assumption that if EU officials can stabilise the financial markets, real economy will continue to rebound into the year end, supporting further gains in stock and risk currencies such as the EUR/USD and the Aussie. 

This upcoming week could prove critical to the financial markets as EU officials promise to provide a comprehensive plan after the second summit this Wednesday. If markets are convinced, risk assets could gain further, but the rally having gone so far so fast, caution is in order and if EUR/USD rises towards the 1.4100 level it may be a much better sell than a buy at that point. 

The writer is GFT Director of Research Opinion expressed here is his own and do not reflect the views of Gulf News