The broad-based sell-off in the equity, currency and commodity markets on Monday evoked memories of 2008 in the minds of many. The comparison is not out of place. There is a common link between the decline then and now — heightened risk-aversion and de-leveraging.
In 2008 too, there was a widespread decline in almost all asset classes. With the collapse in the US housing market prices, there were heavy defaults in sub-prime mortgages. This, in turn, made the market for mortgage-backed securities and credit-default swaps collapse. The panic among investors as they rushed to sell profitable assets in other regions in a classic risk off trade is captured by volatility indices.
The CBOE volatility index (VIX) spiked to the highest of 89.5 in October 2008, following the Lehman Brothers bankruptcy. Such a high degree of risk-aversion is generally accompanied by investors rushing to sell assets held across the globe to repay the loans taken to finance these trades. Risk-off trades are also accompanied by money flowing in to safe havens.
Since around 50 per cent of global funds originate from the US, money generally tends to flow back in to assets denominated in US dollars such as US treasury securities in such situations. A similar spike in risk aversion was noticed last week with the CBOE VIX spiking to 28, recording a 120 per cent increase. This index is also called the investors’ fear gauge and measures the expectation of traders regarding market’s future movement. This is the sharpest increase recorded in the index since 2011.
Similarly, on Monday, the Nifty VIX that tracks the expectation of Indian traders, moved up to 28, up 64 per cent.
While the Chinese slowdown and its impact on global growth was the most important factor playing on investors’ minds on Monday, many who had used the “dollar carry trade” to purchase assets world-wide would also have contributed to this slide.
With the US Federal Reserve slashing its target fund rate to between 0 and 0.25 per cent to combat slow-down, many non-US residents, have lent to borrowers across the globe resulting, in a flourishing US dollar carry trade since 2009. If the Fed begins increasing rates, increase in dollar value will result in a higher outgo on their loan repayments.