Here’s an interesting view.
Is the search for yield getting in the way of all rational sense in the market?
BNY Mellon’s Simon Derrick, currency strategist, makes the point that investors are somewhat taking leave of their senses when faced with the choice of extra yield versus added risk or crisis exposure.
As he noted on Thursday (our emphasis):
In yesterday’s morning briefing we drew an analogy between recent events impacting on EUR/USD and the situation in late summer and early autumn of last year. In particular we highlighted how the EUR managed to shrug off a cut in Ireland’s credit rating by Standard & Poor’s, a worse than expected Q2 GDP number as well as downgrade of Anglo Irish debt by Moody’s Investors Services. This came despite clear warning signals emerging from the underlying fixed income markets (the 10-year Irish/German yield gap was ballooning outwards from August onwards).
Instead, it took a full scale collapse of confidence in Ireland (flagged by the move in the 5-year CDS in late October) to make investors turn from focussing on the imminent introduction of QE2 in the US and the “currency wars” saga. This is hardly the first time in recent years when a focus on the attraction of the USD as a cheap funding currency has, seemingly, led investors to ignore a brewing crisis.
Over the course of the past two weeks we have also spent some time discussing the events of the second half of 2007 and the first half of 2008. In particular we have highlighted the negative impact that a soaring oil price had on a variety of emerging equity markets as well as on the price of commodities such as wheat as investors began to factor in a slowdown in global growth in the opening months of that year.
Yet, despite this, participants in the currency markets continued to buy the EUR all the way through until mid-July when it finally spiked briefly above USD1.60 (spurred on by a particularly ill-timed rate hike by the ECB) before collapsing through August and early September (it was already trading below USD 1.40 by the time the Lehman’s crisis hit). Looking further back it could be argued that the first real example of this apparent willingness to ignore very real dangers in favour of simply picking up yield (often likened to “picking up pennies in front of a steamroller”) came during the second half of the 1990’s.
Despite a rolling emerging market crisis that had originated in July 1997 in Thailand and had reached as far as South Africa by April of 1998, the JPY funded carry trade had remained popular through until early August of 1998 when the combination of the Russian crisis and a notable change of stance by the Fed saw the trade begin to unwind. Following the collapse of Long term Capital Management at the end of September and a subsequent broad retreat from risk in the days afterwards, October 7th became one of the more notable days in foreign exchange history as USD/JPY collapsed 12 big figures as everyone headed for the exit door at the same time.
Our reason for raising these stories in this context is not simply a nostalgic impulse on our part (we usually save this for old records). Rather, it is to highlight the point that the most widely adopted trading style of the past fifteen years or so has been the “carry trade” (although we prefer to think of it as a flight from selective currencies). As such, the recent price activity in the currency markets (continuing to shun the USD in favour of a EUR seemingly supported by the seemingly hawkish stance of the ECB) is entirely typical of the trading environment of the past decade and a half.
Moreover, given the role that funding currencies have played, it is logical that they will only begin to strengthen when there are simply no more investments that anyone wishes to fund. In other words it is entirely rational that forex should be almost the last market to react to a developing crisis but that when it does the response will tend to be dramatic.
If this is true then our job is less to forecast how far the trend could extend by (how long is a piece of string?) but, rather, to continue to track developments in other markets. So far we have highlighted, European yield gaps, the price of credit default swaps for peripheral Eurozone sovereign debt along with the price of oil as being potential early warning signals of a break down in the current trend. With the situation in North Africa becoming ever more complicated we suspect that we will find more in the days ahead.
Picking up pennies in front of a steamroller is definitely one way of putting it. Although another way is picking up pennies in front of a cohort of tanks (on their way to battle).
Which brings us to what Ken Rogoff, Harvard economist and former chief economist at the IMF, was saying just this week regarding the fine balance between risk and return.
As he suggests, could the problem be that the world has got too accustomed to the concept of yield or “interest rates” altogether. Could the investing world — including the average depositor — have gotten too greedy and complacent about the sorts of returns they should expect from debt-like instruments?
It’s something that could explain the arguably unhealthy preference for debt over equity in the world today, according to Rogoff.
As he puts it (our emphasis):
Many countries’ tax systems hugely favor debt over equity. The housing boom in the United States might never have reached the proportions that it did if homeowners had been unable to treat interest payments on home loans as a tax deduction.
Corporations are allowed to deduct interest payments on bonds, but stock dividends are effectively taxed at the both the corporate and the individual level. Central banks and finance ministries are also complicit, since debt gets bailed out far more aggressively than equity does.
But, contrary to populist rhetoric, it is not just rich, well-connected bondholders who get bailed out. Many small savers place their savings in so-called money-market funds that pay a premium over ordinary federally insured deposits. Shouldn’t they expect to face risk?
Yet a critical moment in the crisis came when, shortly after the mid-September 2008 collapse of Lehman Brothers, a money-market fund “broke the buck” and couldn’t pay 100 cents on the dollar. Of course, it was bailed out along with all the other money-market funds. I am not advocating a return to the early Middle Ages, when Church usury laws forbade interest on loans.
Back then, financial-market participants had to devise fantastic schemes and contortions to disguise interest payments. Yet today the pendulum has arguably swung too far in the opposite direction. Perhaps scholars who argue that Islamic financial systems’ prohibition on interest generates massive inefficiencies ought to be looking at these systems for positive ideas that Western policymakers might adopt.
Which means debt preferences might actually be skewing the economic balance overall — largely to do with incorrectly evaluated risk exposures.
But, as Rogoff rightly notes, reprogramming the investor-mind set towards the notion that equities are ultimately a more secure investment in terms of risk than debt – thus developing an equity preference amongst the risk averse — is unlikely to be easy.
It’s made harder by the fact that authorities so readily judge debt as the key risk-free benchmark, a benchmark which they see rationally generating a more than notional return. And a return they feel every investor is entitled to receive.
As Rogoff states:
Unfortunately, overcoming the deeply ingrained debt bias in rich-world financial systems will not be easy. In the US, for example, no politician is anxious to say that home-mortgage deductions should be eliminated, or that dividend payments should be tax-free.
There’s nothing like a free lunch is the point. And on that basis the risk-free rate may have been a free lunch that lasted a few decades too long.
If you want a return you should logically, after all, have to take some sort of risk.
And perhaps it’s because there is an adjustment under way that so many debt investors are seemingly taking leave of their senses at the moment.
Food for thought.
Related links:
Global Imbalances without Tears – Project Syndicate
Who’s capturing yield? – FT Alphaville
Goodbye to the risk-free rate – FT Alphaville