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US equity volatility persists as credit markets end year calmly – risk monitor

With the exception of U.S. equities, the warning signals that were flashing red for investors at the height of the COVID-19 financial market panic have returned to green after a tumultuous year.

The coronavirus pandemic sent shockwaves through financial markets in March with credit spreads ballooning, the value of leveraged loans collapsing, and expected volatility in U.S. equities reaching record highs.

"Overall, it's been a whirlwind of a year for investors, with chaos in the first quarter and then a dramatic recovery rally that's taken some markets to all-time highs," Russ Mould, investment director at AJ Bell, wrote in a market commentary.

At its peak in mid-March, the volatility index or VIX surged to a record reading of 82.7, having averaged 13.9 in January and 19.6 in February. The metric has remained stubbornly higher than the pre-pandemic level, even as the S&P 500 broke new ground.

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The VIX had been grinding lower after the uncertainty of the U.S. election passed in November, though a 3.6-point spike to 25.2 on Dec. 21 was the largest jump since Oct. 28 in the runup to the vote.

"The COVID crisis and Brexit uncertainty look set to hang over equities for the rest of the calendar year and January could be a difficult period unless there is progress in getting the virus under control and clarity on when more people will get vaccinated," Mould said.

The unwinding of the COVID-19 effect has been more complete in the credit markets.

The ICE Bank of America investment-grade corporate spread versus Treasurys ballooned from 102 basis points on Feb. 19 to a peak of 401 bps on March 23 and has gradually undone that widening, aided by extensive support from the Federal Reserve. As of Dec. 18, the spread was down to 107 bps, a reversal of 98.3% of the increase.

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It was a similar story in the U.S. high-yield and emerging-market corporate bond segments, which have reversed 93.4% and 91.3% of their respective widenings.

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"Ongoing policy easing continues to support risk assets, with U.S. stocks making new record highs, credit spreads rallying and Bitcoin breaching $20,000 for the first time," Mark Dowding, CIO at BlueBay Asset Management, wrote in a market outlook.

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The leveraged-loan market was another asset class that flashed red for a while. The share of issues priced below 80 cents on the dollar, a closely watched indicator suggesting a company is more likely to default, jumped to 56.8% on March 23 from just 5.1% at the start of March.

That level gradually normalized and by Dec. 18 was just 2.21%, the lowest level since May 2019.

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The pandemic also briefly unsettled banks, with the Libor-OIS spread, a key risk indicator for the U.S. banking sector measuring the difference between the three-month dollar London interbank offered rate and the overnight indexed swap rate, jumping from 17.2 on March 1 to 138.7 on March 27.

However, the actions of the Fed helped this metric to recover quicker than any other, returning below 17.2 by mid-July. As of Dec. 21, Libor-OIS was 13.5 bps, less than half its measurement of 32.6 at the start of the year.

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