31/10/2008: Is that the sound of a bubble in the making?

The back-story is well known now. Even Alan Greenspan, former maestro and current scapegoat for the financial crisis, seems at last to acknowledge it. To fend off a recession after the tech bubble burst in 2000, excessively lax US monetary policy led straight to two even bigger bubbles, in house prices and their next of kin, the credit markets.

The bursting of these two bubbles, in the US and elsewhere, has had profound consequences that are not yet behind us. Not least, it has pushed the US and Europe to the brink of deep and prolonged recessions that we expect them to enter next year.

And again, as in 2001, the question now is how to avoid or at least mitigate the effects of a recession.

This time, monetary policy may not work. Despite deep cuts to interest rates, the Fed has been unable to stave off a serious credit crunch. In fact, virtually all the world’s major central banks are now on the rate-easing path. But with commercial banks and other lenders focusing on reducing their own debt and replenishing their own balance sheets, liquidity remains frozen and money is still not finding its way to the public.

With credit channels for businesses and private borrowers still blocked, governments will probably have to turn to fiscal policy measures next. Here again the US paved the way, starting last spring with a 150 billion US dollar impulse program, mostly in form of tax rebates. Another fiscal program is currently being prepared. Other countries, most notably the UK and France, are now considering similar measures. The recently-scorned ideas of John Maynard Keynes are back, alive and kicking, much to the chagrin of many economists.

But how will the US government pay for its high-ticket interventions? The answer is simple: it will just increase its debt. Today, everyone’s chasing the safest and most liquid paper, which is government debt, especially from the US. With roughly a 3.5% yield on 10-year US Treasury paper, financing its budget deficit has become especially cheap for the US government. So far, so good. There is nothing wrong with profiting from good financing conditions.

But is this also a good deal for the investor? Here, we are far less certain. Once the financial crisis begins to fade, the risk premium on asset classes like equities or corporate bonds will fall. Investors might suddenly become nervous about the towering deficit and debt-to-GDP ratio accumulating in the US. And this realization might lead them to exit the US government bond market as fast as they entered it. This would turn today’s favorable picture on its head and lead to sharply higher interest rates and lower bond prices.

Some economists would cite Japan as proof that low interest rates are not inherently incompatible with an extremely high government debt-to-GDP ratio (now estimated to be around 180% in Japan). But almost all of Japan’s government debt is financed domestically, while a large chunk of US debt is held abroad. And here lurks a huge risk, in our opinion.

Having financed US corporate debt during the tech bubble and then US consumer debt during the housing bubble, we wonder if the rest of the world will line up to finance US government debt. If enough former backers sit this round out, we just might end up with a big, nasty US Treasury bubble.

“Fool me once shame on you, fool me twice shame on me.” Being fooled a third time invites the question, are we investors, or masochists? We think fiscal policy measures may prove to be a bit more problematic against this recession than some government economists seem to acknowledge.

17/10/2008: Ignore fundamentals and they will seek revenge

This is a basic rule of investing. It has been recently once again proven right. This time it was in the foreign exchange market.

During the last five years at least foreign exchange markets were dominated by a practice called “carry trade”. Carry trade consists of borrowing funds in a low- interest rate currency and investing the proceeds in a high- interest rate currency. For example taking a mortgage in the Swiss Franc characterized by a very low interest rate and buying real estate in another country whose interest rates are higher. The yield difference between the two countries or the two currencies represents a gain if the exchange rate does not move to such an extent that it will erase the interest rate differential. If such a strategy is broadly adopted, as was the case in the last couple of years, then the price value of the low-yielding currency will decline and the price value of the high-yielding currency will go up.

This sounds like a money-spinner but, as we all (should) know, there is no such thing as a free lunch, or a perpetual profit maker. So where is the flaw in this practice?

First and foremost, one needs to acknowledge that interest rates are usually a reflection of inflation expectations. The countries, which are seen as having a low inflation track like Switzerland or Japan enjoy usually comparatively low interest rates and conversely countries with a less optimal inflation track, like Australia or New Zealand have comparatively higher interest rates. According to the purchasing power parity, low inflation countries will see in the long run their currencies strengthen against higher inflation countries. In fact over a period of 20 years the Swiss Franc and the Japanese Yen have clearly appreciated against almost all other currencies in the world.

Second, a low interest rate is also a reflection of the fact that a country is seen as safe and stable. This explains why usually developed countries have lower interest rates than emerging markets and have in the long run currencies, which are more stable.

Despite these fundamental explanations, why in the long run low yielding currencies tend to appreciate against high yielding currencies carry trades enjoyed the investors’ favor of investors in the last couple of years, reflecting their robust risk appetite. The exchange rate between the Japanese yen and the Australian dollar, which encompasses one of the more favored carry trades – sell the former and buy the latter – was almost mimicking the evolution of the Standard & Poor’s 500 equity index. Therefore there was a close relationship between successful carry trading and equity performance, one gauge of overall market sentiment.

Like every other risky strategy carry trades have been hit hard by the ongoing financial crisis to the extent that we consider them to be over by now. Over the last month alone the high yielding and once favored Australian dollar lost more than 40% against the low yielding and once despised Japanese yen.

In our view, carry trades are now clearly out of fashion on the currency market and it is not yet clear which new theme will drive the market over the medium run. Meanwhile, and at least as long as the crisis last we low- yielding, safe-haven currencies like the Japanese yen and the Swiss franc over higher- yielding currencies, like the euro, the British pound or the Australian dollar.

03/10/2008: On the road to inflation or deflation?

Government debt is soaring as the US and Europe scramble to rescue distressed financial institutions. Central banks worldwide are pumping liquidity into markets and lowering their interest rates. Classical economic theory argues that these actions should pave the way for a surge in inflation pressures ahead. But is it really so?

Economic textbooks generally take the view that two government actions can be counted on to fan the flames of inflation––printing more money or increasing government debt. While few economists would dispute this thesis, there can be exceptional circumstances that defy it, and this is what we now are seeing.

Money is created from two sources: a central bank, like the US Fed, and financial institutions, like commercial banks. When the central bank wants to create money, it simply prints it and then buys something with it, such as government debt. The “new” money goes to the seller of the government debt, who in turn buys something or saves it.

At some point, this freshly created money lands in a bank’s accounts. The bank will lend most of this money to someone, who will buy something with it; at some point the money will land in another bank account; that bank will lend most of the money to someone else; and the cycle continues.

In a smoothly functioning financial system, one unit of central bank money, or base money, thus creates multiple units of money in the real economy. How much it creates depends on the reserve requirements of banks that stipulate the proportion of deposits that must keep at the central bank rather than lent. It also depends on interest rate levels and on the willingness of banks to lend.

In today’s dysfunctional financial markets, the willingness to lend has abruptly vanished, especially in the US. This means that the Fed can print money, but these funds will not find their way to the public via loans and will therefore have no affect on demand, prices, and inflation.

After the Japanese real estate and stock markets collapsed in 1990, the Bank of Japan and the Japanese government confronted a situation similar to what the US and to a lesser extent Europe now face. Despite years of central bank interest rates at zero percent and government debt that ballooned to more than 150% of GDP, Japan actually experienced more than ten years of deflation, that is, declining prices, because banks drastically reduced lending and deleveraged, that is, they removed debt from their balance sheets.

Both inflation and deflation hurt equities, but inflation is obviously the lesser of the two evils as the Great Depression of the 1930s and Japan in the 1990s both confirm. Bonds, especially the safest ones, tend to perform well in a deflationary environment; so does currency, even if its returns are low. Commodities, on the other hand, do well in times of rising inflation and less well when deflation prevails.

Thus, the view that money creation automatically feeds inflation does not neatly apply in the current situation. The environment is more complex this time around, which means that making the right investment decisions will be absolutely crucial to your portfolio once the worst of the current crisis is behind us.