Creeping rates, risk, volatility may rein in rally

LONDON (Reuters) - Even as the three-month-old global equity market rally nudges new highs this week, the threat of fresh financial stress from surging government bond yields is adding to arguments for at least a breather.

And simple market logic suggests an awful lot of positive news on the prevailing economic stabilization has already been factored in during the near 50 percent rally in world stocks .MIWD00000PUS since March.

Economic Armageddon may have been avoided, for sure, but the jury is still out on a self-sustaining return to long-term economic growth trends.

What is more, rising government borrowing rates in the United States and around the world will do nothing to aid that recovery as they push long-term mortgage and corporate borrowing costs up too.

Ten-year U.S. Treasury borrowing rates have jumped more than half a percentage point in the past month, while U.S. 30-year fixed mortgage rates jumped 0.44 percentage point last week alone. Ten-year euro government benchmarks have also added more than 0.4 percentage point in a month.

Crucially, these long-term interest rate rises have come independently of moves in official central bank rates -- which remain anchored close to zero -- thus steepening the yield curve, the difference between short and long-term rates.

"The last thing the U.S. economy needs is higher interest rates and mortgage rates, but that's what's happening and this can't be helpful," said Richard Batty, Investment Director at Standard Life Investments in Edinburgh. He retains a "balanced" view of equities and a relatively defensive portfolio.

"We haven't been prepared to chase risk assets given our concerns about how world is shaping up," said Batty, adding that financial volatility remains historically very high despite declining sharply from crisis peaks.

"Markets do pause for breath and we think this recovery will be pretty muted."

BEWARE OF RESURGENT VOLATILITY

Reading the runes of price volatility and market trading models may ring the loudest alarm bell for this current rally. Measures of both historical and implied market volatility -- not market direction alone -- are critical traffic signals for investment.

Interest rate and bond volatility has spiked higher over the past week as U.S. government debt prices lunged on concern about rising fiscal deficits, dollar weakness and long-term inflation.

Societe Generale points out that realized or observed volatility on 10-year Treasuries has jumped back toward crisis peaks above 10 basis points per day -- levels that would have marked extreme peaks looking back over the past decade.

Bond analysts also look to implied volatilities derived from swaptions -- options to enter into interest rate swaps in the future -- as a bellwether for interest rate volatility at large.

These too have soared over the past week. UBS estimates swaption volatility levels have jumped by up to 25 percent in a month.

And even equity market volatility, which more than halved from the peaks of last October, looks to have found a floor this week despite further gains in benchmark indices. Some worry that, unusually, further equity gains from here may even register higher and not lower volatility.

Implied volatilities on Wall St stocks captured by the VIX .VIX index, dubbed the "fear gauge," soared to record highs close to 90 percent last October after the Lehman collapse.

This has been slashed to 30 percent since, but remains historically very high. The index was mostly below 20 percent for the four years prior to the onset of the credit crunch in the summer of 2007 and has traded above 30 percent on only a handful of occasions of extreme global stress during the past 20 years.

Although the S&P500 .SPX continued to set new cycle highs this week, the VIX actually troughed on May 20 and has struggled to stay below 30 percent ever since.

All this is important because embedded in risk management models of investment funds and banks around the world, volatility gauges are essentially used as proxies for risk. When implied volatility is high or rising, for example, Value-at-Risk models instruct investors to sell those assets or at least demand additional compensation for the greater chance of losing their shirts.

Just as soaring volatility during the worst of the credit crunch automatically herded asset managers out of relatively risky positions in equity, credit and emerging markets into "safe" U.S. Treasury bonds and bills, so too has the retreat in volatility of recent weeks freed them to return.

"I'm very skeptical about this market recovery," said Meyrick Chapman, strategist at UBS in London, pointing out the recent spike in bond and interest rate swap volatilities as an example of the underlying fragility of the markets.

"Our models assume a steeper yield curve is a sign of risk aversion and reduced risk appetite -- and this should be associated with equity markets turning over."

(Editing by Ruth Pitchford)