COLUMN-Russia worries in a low-volatility world: James Saft

Tue Jul 22, 2014 12:01am EDT

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

July 22 (Reuters) - Rising tensions between Russia and the West are doing what central bankers can't or won't: scare investors.

Global stock markets fell for a third straight session on Monday, driven in substantial part by rising tensions after the downing of a civilian airplane over Ukraine.

The U.S. blames the destruction of a Malaysian Airlines jet on pro-Russian fighters armed by Russia, and EU and U.S. officials are threatening stronger sanctions on Russia, contributing to a spike in volatility and a fall in most risky assets.

Contrast that to the mild reaction to a rare and specific warning last week from Fed Chair Janet Yellen about debt markets and social media and biotech shares. Or, for that matter the relative unconcern investors have displayed about the Banco Espirito Santo mess, which threatens the patched-together consensus about how best to buttress Europe's banks.

We suddenly have a source of volatility in what has been an exceptionally placid landscape.

On the theory that you can learn a lot about a person by studying what they fear and why, all of this calls for a close look at the assumptions investors appear to be making.

As ever, the first and often best answer for why a price moved is that it ought to have, and tensions with Russia may be no exception.

Sanctions imposed on Russia, whatever their merits, carry with them undeniable costs for both sides. Specifically Russia is a major trading partner with the European Union, and maybe more importantly a key supplier of energy, one with a track record of using energy aggressively.

Remember too that while a central bank can create more money and easier credit, neither the ECB nor the Federal Reserve has oil or natural gas reserves. And while the U.S. does have reserves, there is no way for the punitive sanctions to be put into place without a measure of blowback for the economies of those imposing them.

GENUINE OLD-FASHIONED VOLATILITY

Perhaps the best reason events have thrown a scare into investors is that Russia is hugely unpredictable.

Russia under Putin is not a profit-and-GDP-maximizing entity in the manner of most nation-states, but instead something far more unpredictable. That makes taking bets on its future behavior much more difficult. The net result is volatility in pricing and a higher risk premium on financial assets.

"The threat of an open Russian war against Ukraine is the biggest tail risk to our cautiously positive outlook for the euro zone economy," writes Holger Schmieding, economist at Berenberg Bank in London, in a note to clients.

"The direct loss in trade with Russia and, more importantly, the impact of the current conflict on confidence is one key factor which currently keeps the euro zone economic recovery a bit more muted than we had expected at the end of last year."

When economists, or financial commentators, are making calculations about what Putin will do next, investors can be excused if they decide this is not a game they wish to play. The result is not policy-engineered volatility, or the kind that comes from an economic surprise, but a more genuine old-fashioned uncertainty of which most of us have very little experience.

This also illustrates even more starkly the extent to which investors seem to take it for granted that central bankers will act in a risk-friendly way. Yellen arguably did her best to spook the market, or parts of it, last week when she and colleagues at the Fed expressed concern over some sectors of the stock and debt markets.

This had remarkably little effect, especially given how rare such a calling out is. More than six years into the era of extraordinary policy, risk investors take it for granted that their interests and those of central bankers are aligned, that the economy can't function without easy credit and aggressive valuations. Yellen's warnings about the market are undermined by what she says about the economy, and what she's said about not using monetary policy to lance bubbles.

Similarly, investors in debt issued by Portugal and other weaker euro zone nations are tending to take it for granted that the ECB and other euro zone authorities will see to the health of the banking system. That's actually right and proper, especially if it comes along with an acknowledgement that lenders to weak banks will bear their portion of the risks.

Still, while more unpredictable policy making would be no good thing, the extent to which the markets put faith that everyone's loaf will be buttered by policy is dangerous.

Higher risk premiums over geopolitical tensions are probably justified, but these are not the only potential sources of trouble.

What happens with Russia and Ukraine is unknowable, but central bank support can and likely will eventually be withdrawn. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)