Risks posed by trade war and Federal Reserve policy are graver than investors seem to realise

Markets must come to terms with the fact that China and the US are too far apart on crucial issues for the trade war to be resolved soon

When central banks themselves have become sources of volatility, investors must wake up to the dangers of underpricing risk

Reading Time:3 minutes

Traders work on the floor of the New York Stock Exchange, flanked by a television screen showing Federal Reserve chairman Jerome Powell’s news conference on June 19. Photo: Reuters

Published: 1:00pm, 20 Jun 2019Updated: 10:29pm, 20 Jun 2019

Have financial markets become too complacent? At first glance, it is difficult to argue that investors are not paying enough attention to the two most important issues facing markets: the US-China trade war and the conduct of American monetary policy.

At the end of last year, US stock markets suffered their worst December since 1931 due to fears that the Federal Reserve was underestimating the deterioration in global growth and was hell-bent on tightening policy further. When the Fed began signalling in early January that it was prepared to change course by putting its interest-rate-increase campaign on hold, markets roared back, with the yield on benchmark 10-year Treasury bonds falling nearly 80 basis points since mid-January to just over 2 per cent.

Investors also took fright at the severe escalation of the trade war early last month, when US President Donald Trump moved to restrict the access of Huawei Technologies to America’s market and suppliers, shifting the focus of the conflict to the all-important technology sector. The New York Stock Exchange’s FANG+ index, which tracks a basket of global tech companies, is down 10.6 per cent since May 3.

Yet, closely watched measures of financial volatility remain remarkably subdued, and have even fallen since Trump revived his trade offensive against China. The VIX Index, Wall Street’s so-called fear gauge which measures the implied volatility of the S&P 500 equity index based on options prices, is down 30 per cent since May 13, and as much as 60 per cent since the height of the sell-off last December. Indeed, the S&P 500 itself currently stands a mere 0.6 per cent below its all-time high set on May 3.

A report published by JPMorgan last Friday, which looked at a dozen gauges of volatility across five separate asset classes, noted that “option markets do not embed enough cushion against the significant event risk markets are facing over the coming weeks”. How much extra cushion there should be is debatable. What is clear is that investors are significantly underpricing the risks surrounding the Fed and the trade war.

It is shocking that only six months after the Fed was intending to raise rates two times in 2019, bond markets are now pricing in at least two cuts by the end of this year, and assigning a 100 per cent probability to a reduction next month.

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