Tuesday, 24 November 2009

China's credit growth worries...

China stood out this year as the one economy apparently not stalled by the global economic crisis, but their continued growth was brought about by rapid credit extension - always a worrisome aspect. FT.com reported the following story how Chinese banks will have to seek additional capital to prop up their capital adequacy ratios:
China’s banks are preparing to raise tens of billions of dollars in additional capital to meet regulatory requirements following an unprecedented expansion of new loans this year, according to people familiar with the matter.
China’s 11 largest listed banks will have to raise at least Rmb300bn ($43bn) to meet more stringent capital adequacy requirements and maintain loan growth and business expansion, according to estimates from BNP Paribas.
China’s banking regulator has warned it would refuse approvals for expansion and limit banking operations if lenders did not meet new capital adequacy requirements, a move that has prompted the country’s largest state-owned banks to prepare capital-raising plans for next year and beyond.
China’s banking regulator is definitely aware of potential asset quality issues and is pushing for higher capital adequacy requirements to offset deterioration in asset quality.
Following government orders to prop up the domestic economy in the face of the global crisis, Chinese banks extended a record Rmb8,920bn in loans in the first 10 months of the year, up by Rmb5,260bn from the same period a year earlier.
This unprecedented loan expansion resulted in a record fall in their core capital adequacy rates from just over 10 per cent at the end of last year to 8.89 per cent by the end of September, a drop that worries regulators.
A spokesman from the banking regulator said the vast majority of Chinese commercial banks met current capital adequacy requirements but lenders were expected to conduct reviews of their asset quality and ensure they continue to meet regulatory requirements.

Wednesday, 18 November 2009

The advent of the Efficient Market Hypothesis

Richard Thaler, professor of economics and behavioral science at the University of Chicago commented in a FT.com article about how the theory of Efficient Markets (otherwise known as EMH) led many to believe that the market should always be right. Hence, we have witnessed in recent years some gross policy errors and mistaken beliefs.

The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.
The EMH has two components that I call "The Price is Right" and "No Free Lunch". The price is right principle says asset prices will "fully reflect" available information, and thus "provide accurate signals for resource allocation". The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.
For many years the EMH was "taken as a fact of life" by economists. However, as early as 1984 Robert Shiller, the economist, correctly and boldly called this "one of the most remarkable errors in the history of economic thought". The reason this is an error is that prices can be unpredictable and still wrong; the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable.
Simply put, it is hard to reject the claim that prices are right unless you have a theory of how prices are supposed to behave. For example, stock market observers - as early as Benjamin Graham in the 1930s - noted the odd fact that the prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own. This violates the basic building block of finance - the law of one price - and does not depend on any pricing model.
Compared to the price is right component, the no free lunch aspect of the EMH has fared better. Mr Michael Jensen's doctoral thesis published in 1968 set the right tone when he found that, as a group, mutual fund managers could not outperform the market. There have been dozens of studies since then, but the basic conclusion is the same. Although there are some anomalies, the market seems hard to beat. That does not prevent people from trying. For years people predictedfees paid to money managers would fall as investors switched to index funds or cheaper passive strategies, but instead assets were directed to hedge funds that charge very high fees.
Now, a year into the crisis, where has it left the advocates of the EMH? On the free lunch component there are two lessons. The first is that many investments have risks that are more correlated than they appear. The second is that high returns that are based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist.
So where does this leave us? Counting the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be "right", then these bubbles would not occur.
While imperfect, financial markets are still the best way to allocate capital.

Not-so-efficient markets...

John Kay, author and columnist for Financial Times, wrote an article about the existing views on efficient markets. Here follows some excerpts:

Warren Buffett said most of what you need to know about efficient markets. “Observing correctly that the market was frequently efficient, they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.”
Mr Buffett has made his money not from the part that is frequently efficient, but from the part that is infrequently inefficient.
The efficient market hypothesis has been the bedrock of financial economics for almost 50 years. Market efficiency is a hypothesis about the way markets react to information and does not necessarily imply that markets promote economic efficiency in a wider sense. But there is a relationship between the two concepts of efficiency.
There are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.

These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.
Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.
The weak efficient market theory tells us that past prices are no guide to what will happen to security prices in future. There is a good deal of evidence for this claim: you would be as well employed studying the patterns on your palm as patterns on charts. But there is also evidence of a tendency for short-term price movements to continue in the same direction – momentum is real. If you know precisely when the short term becomes the long term, this would make you very rich. It is possible to make money – or policy – through reading boom-and-bust cycles. But most participants do not.
The semi-strong version of the theory claims that markets reflect all publicly available information about securities. What is general knowledge will be in the price. But inside information, or original analysis, might add value.

The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies.

Friday, 13 November 2009

False ideas don't survive...

Martin Wolf, chief economics reporter for the Financial Times, recently reviewed a new book by Andrew Smithers: Wall Street Revalued: Imperfect Markets and Inept Central Bankers.
The big points of the book are four: first, asset markets are only "imperfectly efficient"; second, it is possible to value markets; third, huge positive deviations from fair value - bubbles - are economically devastating, particularly if associated with credit surges and underpricing of liquidity; and, finally, central banks should try to prick such bubbles. "We must be prepared to consider the possibility that periodic mild recessions are a necessary price for avoiding major ones." I have been unwilling to accept this view. That is no longer true.
The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a "random walk". Mr Smithers shows that this conclusion is empirically false: stock markets exhibit "negative serial correlation". More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. "Markets rotate around fair value." There is, Mr Smithers also shows, reason to believe this is true of other markets in real assets - including housing.
A standard objection is that if markets deviate from fair value, they must present chances for arbitrage. Mr Smithers demonstrates that the length of time over which markets deviate is so long (decades) and their movement so unpredictable that this opportunity cannot be exploited. A short seller will go broke long before the value ship comes in. Similarly, someone who borrows to buy shares when they are cheap has an excellent chance of losing everything before the gamble pays off. The difficulty of exploiting such opportunities is large for professional managers, who will lose clients. The graveyard of finance contains those who were right too soon.
Mr Smithers proposes two fundamental measures of value - "Q" or the valuation ratio, which relates the market value of stocks to the net worth of companies and the cyclically adjusted price-earnings ratio, which relates current market value to a 10-year moving average of past real earnings. Professional managers use many other valuation methods, all of them false. As Mr Smithers remarks sardonically: "Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth."
Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back. Trees do not grow to the sky and markets do not attain infinite value. When stocks reach absurd valuations, investors will stop buying and start to sell. In the end, the value of stocks will move back into line with (or below) the value - and underlying earnings - of companies. House prices will, in the long term, also relate to incomes.
The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. "Leaning against the wind" requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned.

Thursday, 12 November 2009

Not all bubbles are the same...

Frederic Mishkin, author and professor of finance at Columbia University and a former member of the Fed Board, believes not all asset-price bubbles are dangerous and one has to understand the underlying drivers before panicking about the effects of very accommodating monetary policies. Excerpts from an article that was published on FT.com follows:
There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no.
Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.
Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.
The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.
Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker.
Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.
But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.
Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture.

Tuesday, 10 November 2009

The world is flat...

Ricco Friedrich, a portfolio manager at Sanlam Investment Management, listed recently his seven myths of investing in a weekly newsletter published by Glacier Research:

Myths are widely held beliefs that are mistaken as truths. For example, for long periods of time people believed (and acted) as if the world was flat. Below are similarly misguided assumptions that exist in the financial markets that I have come across during my investment career. I have found the reality that lies behind these to be invaluable in guiding my investment decisions.

Myth 1 - There is no free lunch
While I subscribe to the aphorism, “If something is too good to be true, it probably is”, I believe there is one free lunch in the financial markets, the impact of which is often understated. This has often been referred to as the eighth wonder of the world and, you’ve guessed it, it’s compounding.
Everyone can benefit from compounding. It is not a zero sum game and it does not require any special insight. The benefit of compounding can best be illustrated by the following example. If you can achieve a return of say 12% a year from your equity portfolio, it will effectively double in value every six years. For every R100 you put away at age 25, you will have R5 279 when you retire at 60. If you delay your savings until you turn 30, your R100 will only be worth a comparable R2 674. So you see it’s the last double that has a material impact on your pension savings, which means you should start saving as early as possible to benefit from the impressive power of compounding.

Myth 2 - Earnings drive share prices
While this may be true in the short term, valuation ultimately trumps short-term earnings expectations. On their own, earnings do not create value for shareholders, dividends do. I have seen several companies that have consistently grown earnings, but at the expense of shareholder value creation, which comes from generating cash and reinvesting the cash back into the business at returns that are above the cost of capital.

Sometimes it takes years for the market to recognize that the emperor is in fact wearing no clothes (i.e. earnings are growing, but not shareholder value). Some examples that come to mind in the past 10 years are CS Holdings and Imperial (prior to its recent unbundling).
Myth 3 - Active managers outperform the market
This is a highly contentious issue and, while some managers do outperform their benchmark, they are certainly in the minority. If you look at the data over the last year, active managers have done quite well. Just over 50% of all unit trust managers in the combined general equity, value and growth category outperformed the JSE All Share Index. But unfortunately as one increases the time horizon, so the statistics get worse. Over 10 years, just one third of all managers beat the JSE All Share Index (and this is ignoring the affects of survivorship bias). Investing in the market is a zero sum game, half will outperform the Index and the other half will not. After taking fees into account, roughly only half of the remaining group (i.e. roughly one quarter) actually beat the JSE All Share Index. While there is no magic formula for beating these odds, a detailed, disciplined and value-oriented approach to investing should swing these odds in your favor.
Myth 4 - You can make money in the long run by investing in Initial Public offerings (IPO’s)
This is one of the biggest myths of all time. If you look back to the 1998 IPO listings boom, there are very few companies that are still listed today. We conducted a study of all the new listings that took place in 2007. Of all the companies that listed in 2007 and 2008, the average return they have delivered is negative 45% on an equal weighted basis. In fact, only two companies are trading above their IPO price. With this track record, you would be much better off just investing in the JSE All Share Index rather than speculating on IPO’s.
The main reason IPO’s perform so poorly is that often the reason for listing is that the current owners of the unlisted business believe they can get more for the company by listing it than it is actually worth. Of course there are some management teams that list for the right reasons and with good intention but these tend to be in the minority.
Myth 5 - Volatility = risk
As investment managers, we believe our goal is to ensure that we achieve our client’s financial objectives by taking on the least amount of risk. In our view, risk does not reside in share price changes and cannot be summarised into a single number, such as the traditional measures used in portfolio management theory. The only risk that really matters is the prospect of a permanent loss of capital because portfolio management theory tells you nothing about the fundamentals of the companies you are investing in, their business risk or their balance sheet risk.

Myth 6 - Markets are efficient

As an active manager, you would, of course, expect us to believe the equity market is inefficient. Most of the time, however, the market is probably efficient. If you view the market as a complex adaptive system, consisting of many participants all pulling in different directions, then on average prices will generally trade at close to fair value. It’s only when the market mechanism breaks down and the scale tips to either side that mispricing opportunities arise. The two most recent examples of this over the past 10 years have been the IT bubble in 2001 and the commodities bubble in 2008.
Myth 7 - We can accurately forecast the future
This may seem obviously false, but many economists, analysts and fund managers spend a large portion of their time trying to forecast the future. Many of these professionals earn large salaries and bonuses irrespective of the accuracy of the outcome of their predictions. I have seen numerous examples of analysts who calculated valuations on companies based on short-term earnings forecasts that never materialized. When the future turned out to be different, so did their forecasts and valuations. What they thought was a bargain, turned out to be a lemon.

Thursday, 5 November 2009

Understanding financial market behaviour...

George Soros, one of the most successful investors ever, published recently his well-thought opinions about how financial markets work and some clues what needs to be done to prevent similar financial crises in the future. Here are some excerpts from the article that appeared on FT.com:

The efficient market hypothesis holds that financial markets tend towards equilibrium and accurately reflect all available information about the future. Deviations from equilibrium are caused by exogenous shocks and occur in a random manner. The crash of 2008 falsified this hypothesis.
I contend that financial markets always present a distorted picture of reality. Moreover, the mispricing of financial assets can affect the so-called fundamentals that the price of those assets is supposed to reflect. That is the principle of reflexivity.
Instead of a tendency towards equilibrium, financial markets have a tendency to develop bubbles. Bubbles are not irrational: it pays to join the crowd, at least for a while. So regulators cannot count on the market to correct its excesses.
The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.
I believe that my analysis of the super-bubble offers clues to the reform that is needed. First, since markets are bubble-prone, financial authorities must accept responsibility for preventing bubbles from growing too big.

Second, to control asset bubbles it is not enough to control the money supply; you must also control credit. The best known means to do so are margin requirements and minimum capital requirements. Currently they are fixed irrespective of the market’s mood because markets are not supposed to have moods. They do, and authorities need to counteract them to prevent asset bubbles growing too large. So they must vary margin and capital requirements. They must also vary the loan-to-value ratio on commercial and residential mortgages to forestall real estate bubbles.

Third, since markets are unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks, believing they can always sell their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. That means the positions of all major participants, including hedge funds and sovereign wealth funds, must be monitored to detect imbalances. Certain derivatives, like credit default swaps, are prone to creating hidden imbalances so they must be regulated, restricted or forbidden.
Fourth, financial markets evolve in a one-directional, non-reversible manner. Financial authorities have extended an implicit guarantee to all institutions that are too big to fail. Withdrawing that guarantee is not credible, therefore they must impose regulations to ensure this guarantee will not be invoked. Such institutions must use less leverage and accept restrictions on how they invest depositors’ money.
It is not the right time to enact permanent reforms. The financial system is far from equilibrium. The short-term needs are the opposite of what is needed in the long term. First you must replace the credit that has evaporated by using the only source that remains credible – the state. That means increasing national debt and extending the monetary base. As the economy stabilises you must shrink this base as fast as credit revives – otherwise, deflation will be replaced by inflation.
We are still in the first phase of this delicate manoeuvre. Banks are earning their way out of a hole. To cut their profitability now would be counterproductive. Reform has to await the second phase, when the money supply needs to be brought under control and carefully phased in so as not to disrupt recovery. But we cannot afford to forget about it.

Wednesday, 4 November 2009

China, forever China?

Not everybody is bullish about the longer term prospects for China. Peter Tasker, a market analyst for a Tokyo-based asset management firm wrote the following article that appeared on FT.com.
Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory.
To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.

Remember that it was in the years following the 1987 "Black Monday" crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei's dizzy rise to 39,000 forced the bears to throw in the towel.
Then, as now, the logic seemed unassailable. While the western world was stuck in the post-crash doldrums, the Japanese economy had got back on track with apparent ease. Japanese corporations were using their high market capitalisations to finance acquisitions of foreign trophy assets. Japanese banks boasted the world's strongest credit ratings.

But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster. And it was the weak western economies, not Japan, that produced healthy investment returns over the next decade.
In reality, 1980s Japan was never going to be terminally damaged by weakness in export markets. Its current account surplus and strong fiscal position provided the macro policy leeway to make any slowdown strictly temporary. The Bank of Japan duly put the pedal to the metal and the recently deregulated banks went on a patriotic lending spree. High-end consumption boomed but the real action was in the asset markets and capital investment, which soared as a proportion of gross domestic product.
Sound familiar? It should, because the same dynamic is evident today in China and some other emerging economies.
Interest rates have been far too low for far too long. If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China's interest rates should have been close to 10 per cent for most of this decade.
Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that "imported" it. The result could only be a massive misallocation of capital.
For most of the 1980s, Japan, like China today, used government direction of bank credit ("window guidance") to overlay monetary policy. It was the combination of banking deregulation and the G7-sanctioned surge in the yen that ushered in the final manic stage of the Japanese bubble. By then there was no way out - asset market collapse and financial system wipe-out were baked in the cake.
If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event, setting off a Godzilla-sized credit binge. Why would China's rulers embark on a such a disastrous course? Because the alternative - unleashing deflationary forces stored up over years of mercantilist policies - would be too painful to contemplate.

Watch out for the unwinding of the carry trade and speculative behaviour!

The famous economist, Nouriel Roubini, recently wrote an article in the Financial Times expressing his concerns about the unwinding of the carry trade (borrowing cheaply in US$ and invest proceeds elsewhere) and its impact on global markets. Here follows some excerpts from the article:
Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes. At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.

The dollar and the sterling have weakened against a host of other currencies since the summer, promoting speculation that they could become the next carry trade currencies and supplant the yen as the ‘funding currency’ of choice.
This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.
But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades.
Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.
Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.
In effect, it has become one big common trade – you short the dollar to buy any global risky assets.
The combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.
While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.
The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. The perfectly correlated bubble across all global asset classes gets bigger by the day.
But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. This renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.
This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.