Jamal Mecklai: Is the music about to stop?

MARKET MANIAC

The major conundrum that has been keeping market analysts and regulators (and conference organisers) in business over the past several years is the odd fact that most measures of risk""from volatilities (of equities, bonds and currencies) to credit spreads (mostly junk bonds and emerging markets)""have been signalling that global investors are very comfortable with risk levels despite the fact of such "obvious" major risk factors as $70 oil and huge global current account imbalances. A collateral aspect of this low risk perception is the amazing bull run in virtually any asset you care to blink at.

This "where is the risk" conundrum has been worrying regulators more and more of late, from the G-7 (who, from time to time, pronounce weightily on the need to do "something" about the imbalances) to our very own Reserve Bank (who hems and haws, when it should be using India's great new credibility to deregulate faster).

But, of course, life has a way of resolving conundrums, and it is beginning to appear as if the new Fed chairman may become the unceremoniously selected instrument. A couple of weeks ago, at a public dinner, Mr Bernanke commented to a (very attractive) financial reporter that the market had misunderstood his Congressional testimony regarding the future course of interest rates. The market had digested his testimony to mean that he believed that the Fed was very close to the end of its long monetary tightening cycle. His comments, which were eagerly broadcast on CNBC, and which seemed to refute this testimony, triggered a bolus of volatility in the bond markets, with the Fed funds expectation for June shooting higher. With the next Fed meeting coming up (on May 10), uncertainty increased, particularly as to how the Fed would explain its forward thinking. In the event, the Fed simply raised rates, as all had expected, but kept the commentary unchanged, as almost nobody expected.

Once again""after a long time""markets are confused. Does the Fed believe that the long series of rate hikes is finally biting into growth? Does it fear that the continuing high oil prices will finally push inflation higher, overriding the deflationary effects of China and India? Is Bernanke really a hawk on inflation? Nobody really has a clue.

The shock wave in the market as a result of Bernanke's comments reminded me of the "simpler" market many, many""at least twenty""years ago. At that time, uncertainty about central bank intentions was a given, and the market waited with bated breath for every move, comment, speech. That was the time when the famous phrase "buy the rumour, sell the fact" was in its element.

Over time with the evolution of the information revolution, the perception of the omnipotence of central banks weakened, as more and more market players began to recognise that they could quite easily second guess policymaking. And from there, it was a simple""if bold""step to driving policymaking, the most famous example of which was when Soros took on the Bank of England. It was clear to him (and many others) that the UK economy was too weak for the Bank of England to raise rates, so he simply kept selling sterling till such time as they had to capitulate, pulling the pound from the ERM and, yes, raising rates.

Throughout these years, there was a loudly adversarial relationship between the market"""speculators" was the favoured word""and the central banks. In fact, much central bank reportage""and policymaking""had to do with keeping speculators off balance. However, starting with Soros and culminating in the Southeast Asian crisis (and the domino effect that it caused), it was clear that increasingly it was the market that called the shots.

And in the middle of all this, with his charming smile, along came Alan Greenspan. Taking guard in the fire and brimstone of the 1987 stock market crash, he learned very quickly the power of the markets. And while he was successful in averting long-term damage by immediately pumping liquidity into the markets, he doubtless understood in a flash that fighting markets is a lose-lose proposition. Rather than trying to push them (a hold-over from the Breton Woods era) or trying to surprise them (during and after the Plaza Accord), far better to""my terminology""romance them.

Of course, to make this happen, it needed a fundamental make-over, a change in mindset, a recognition that speculation, far from destabilising markets, actually improves market performance by increasing liquidity and, yes, reducing risk. I believe that this was Greenspan's greatest legacy""changing the way regulators approached the market. And it was this new "romance" that was responsible for the dramatically lower volatility that has prevailed (till now), which, in turn, is doubtless more than partly responsible for the huge run-up in asset prices that we have all been enjoying.

The problem today is that Greenspan's gone, Bernanke is""obviously""a bit of a greenhorn in such matters, and there are still some old-fashioned central banks about""notably the Bank of Japan""who believe that they dictate terms to, or at least surprise, the market. A dangerous situation, to be sure.

Could the era of central banks' romance with markets be over? And could this result in a sharp increase in uncertainty, volatility, credit spreads and risk aversion? Is this why markets are suddenly nervous?

The author is CEO, Mecklai Financial.