Markets fear experiments are unravelling

"Don't be too timid and squeamish about your actions. All life is an experiment." Central bankers across the world have heeded Ralph Waldo Emerson's advice, but the markets are starting to doubt whether the experiments are working.

Risk aversion infected the markets with a vengeance this week after the Federal Reserve indicated that it might scale back its quantitative easing programme. This was against a backdrop of rising and volatile JGB yields amid uncertainty over the efficacy of "Abenomics", the expansionary monetary policy announced in April by the Bank of Japan.

The recent rally has been largely driven by the liquidity pumped into the financial system by central banks' unconventional policies, and the prospect of the punchbowl being taken away brought the markets back down to earth. The Markit iTraxx Europe was trading at 98.5bps on Friday afternoon, a full 11bps wider than Wednesday's close. Financials have been at the front of the retreat, though it should be noted that panic has not set in - yet.

Eurozone sovereigns enjoy the protection of the ECB, and consequently spread volatility is quite a rare phenomenon in the current climate. But even they relented on Friday, with peripherals widening significantly for the first time since February and France also on the receiving end of negative sentiment.

Reports that Japanese investors are being enticed by rising JGB yields may well have had a detrimental effect on peripheral spreads. Domestic money managers "forced" to look for yields in foreign climes - such as the high-yielding periphery - could be changing their minds. That, at least is the theory. There is little evidence that Japanese investors have been ploughing into foreign assets. It is likely that the inflows into Europe and elsewhere have been non-Japanese investors front running.

Nonetheless, peripheral CDS spreads were on the end of a sell-off on Friday. Spain's CDS widened by 24bps to 235bps, while Italy's spreads were 19bps wider at 250bps. News that Spanish banks will need to increase their provisions by another €10bn added to the pessimism. The Bank of Spain is taking a tougher line on loans to corporates that have been rolled over. This served as a reminder that eurozone banks will probably need a lot more capital in the future when the inevitable debt write-downs start. An EU banking union - and direct recapitalisations through the ESM - still seem a long way off.

We are now set for a choppy two weeks of trading as the markets await the next US non-farm payrolls report. Fed chairman Ben Bernanke reiterated that any change in policy would be predicated on economic data, specifically labour market data. The perfect scenario for the market would be a lacklustre jobs report - a strong upside surprise will trigger fears of the Fed withdrawing support sooner rather than later.

And there is the "Abenomics" experiment". In recent days the Bank of Japan's governor Haruhiko Kuroda has resembled Dr. Frankenstein, horrified at his own creation. Let's hope that he regains control.

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