Skewed and Unhedged

Sovereign debt, when issued by governments of developed nations with long enough track records of not defaulting on their debt, usually command a premium on that debt. This is expressed primarily through lower relative yields across the board. U.S. treasuries, for
example, are frequently viewed as quasi “risk-free” investments1 and used as benchmarks to price other instruments.

In portfolio construction, such “low-risk” instruments are frequently used as “shock absorbers” to counter adverse market conditions when everything else is heading south. There is, of course, a tradeoff involved in owning such instruments: the expected returns tend to be very limited and highly predictable.

This would appear to be a fair enough tradeoff, were it not for the occasional risk altering events that happen when people least expect them. Greece’s 2010 sovereign debt crisis took investors by surprise, not because Greece ever had a pristine track record with its debt, but more because the perception of risk had changed markedly the day it joined the Eurozone.

Like in the example with Greece, there are certain conditions that can engender a substantial mismatch between perceived risk and actual risk. The underlying instrument may appear safe in a vacuum, but changes in the environment can radically alter the realities on the ground.

In statistics the notion of skewness refers to probability distributions that are stretched in one direction2. An example of this would be high yield or junk bonds that offer a high enough probability of expected returns and a low, but real probability of defaulting. Sovereign debt of the “risk free” sort has very different return probability distribution resembling a bell-shaped curve. Skewness is absent because default risk is close to nil.

The current unusually low interest rate environment seems to have altered its distribution. Until recently negative interest rates were thought to be isolated occurrences of limited degree and duration. Now that the zero rate cap has been breached, however, there is no theoretical limit to the size of the “negativity”3.

The skewness in this example arises from the much larger potential for a surge in interest rates. The further interest rates turn negative, the greater is the potential for a sharp reversal. Given the change in the economic environment, U.S. treasuries may very well be at the cusp of a sharp reversal.

Then there is the significant surge in the dollar since the start of the year, another externality that is affecting the risk/return dynamics of sovereign debt in certain segments of the market. Emerging markets have been huge borrowers of U.S. debt over the last couple of years. Low interest rates and the weak dollar have made such borrowing highly attractive in many of these countries where local rates tend to be much higher.

Unlike with the Asian financial crisis of 1997, where the majority of the dollar exposure stemmed from government borrowings, this cycle’s exposure buildup is mainly in the corporate segment. Given that the currency exposure of most of that borrowing was unhedged, the sharp appreciation of the dollar has substantially increased the cost of servicing the debt.

There is an additional “hedge” factor to consider for corporations. It concerns the amount of business (if any) that is conducted in the currency in which the borrowing is taking place. For a firm that conducts all or a large chunk of its business in the currency in which it also borrows, the impact should be minimal. On the other hand, if most or all of its business is conducted domestically, the impact of the exchange rate will be harsh. 

This is why the sharp appreciation of the dollar is a source of market risk in China, Brazil, Russia and Turkey. The longer the dollar remains strong, the more pronounced will be the crisis in the private sector of emerging markets.
If there is any consolation, it may be that the exposure is largely limited to the private sector, reducing the potential for contagion from spreading like it did with the Asian currency crisis of the 90’s. The global economic expansion is unlikely to reverse course, but it could weaken in the second half of the year.

1 The last debt restructuring in the U.S. occurred in 1971. The one before that was in 1933. This contrasts with Venezuela in 2004 and 1998 before that.
2 In contrast to the traditional bell-shaped Gaussian curve where both sides are identical, the skewed curve stretches more in one direction with increasingly lower probabilities of large deviations from the mean.
3 There does come a threshold point where a further rise in the negative interest rate will trigger a massive enough sell off in bonds. That moving target is most likely determined primarily by market conditions and investor sentiment. 

Somewhere Between Deterrence and Action...

At the height of the Cold War in the early 60’s, the U.S. and the Soviet Union were stockpiling nuclear warheads in sufficient quantities to destroy the entire planet many times over.

The nuclear arms race was fuelled in large part by a sense of paranoia between belligerents that were acting on imperfect information. The race soon turned into a “Nash- equilibrium” zero sum game1, as it became clear that no victor could possibly emerge in the event of an all-out nuclear war.

Fortunately the weapons were never deployed2 and although stockpiles have been cut drastically in the post Cold War era, it doesn’t change the fact that the world can still be destroyed many times over. The nuclear threat hasn’t extinguished wars altogether, conflicts still occur albeit at a far smaller scale.

An analogy can be drawn between the Cold War era nuclear deterrent and the various policies and actions central banks have taken over the last couple of years. Threats to financial markets have appeared in many guises, from damage inflicted by speculators to systemic disruptions, the list can be long. Central banks have countered these threats through a combination of words3 and deeds, and the recent past is abundant of examples.

When the global economic crisis started in 2007, the “weapon of choice” was the target rate, which was brought close to zero in a short time span. It soon became clear, however, that more was needed to turn the tides. The ensuing near credit crunch conditions in the fourth quarter of 2008 prompted the Fed and other central banks to use more potent firepower. 

The decision to let Lehman fail was an attempt to stifle moral hazard4 risk, and although the message was loud and clear, it gave markets cold feet. The emerging threat of “credit crunch” paralysis prompted Central banks to purchase a record $2.5 trillion worth of government debt and troubled private assets from banks5.

This was the first wave of a highly potent intervention. It did a lot to stabilize the markets, averting a serious, great- depression like crisis. Soon it became clear, however, that most of the advanced economies were stuck in a protracted, weakened recovery state, necessitating further actions.

These actions occurred, to a large extent, through multiple rounds of quantitative easing (QE) in an attempt to maintain low yields across the maturity spectrum. Just as QE was kicking in and economies seemed poised for a more robust recovery, the European sovereign debt crisis happened in 2010, eroding most of the bullish sentiment that has been forming.

Fear and uncertainty gained traction, prompting speculators to go as far as challenging the existence of the Euro. Peripheral borrowing rates went through the roof, forcing the ECB chief to announce in July 2012 that they were prepared to “do whatever it takes to preserve the Euro. And believe me, it will be enough." This turned out to be a defining moment, the explicit threat combined with the setting up of generous borrowing facilities for struggling member states went a long way to normalizing the situation.

We’ve come a long way from the initial crisis, and new threats are continually appearing. The Eurozone economies and a few other countries are now facing a serious deflation conundrum. With traditional and less conventional tools largely exhausted6, authorities are having to find novel ways to counter the threats. More recently several countries have been experimenting with negative interest rates7.

The idea is that by charging negative rates on bank deposits, central banks could help spur greater lending in the economy. It should also contribute to further weakening the home currency by rendering it somewhat less attractive for both locals and foreigners. The strategy does not seem to be having much of an effect, but it is still early to draw conclusions.

It could be that borrowers don’t see many opportunities for capital spending. Also, financial institutions seem to be absorbing most of the costs probably due to the fierce competition. As the challenges change form, the deterrents and actions adapt, and the saga continues. 

1 The Nash equilibrium is a solution concept of a non-cooperative game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy.
2 We came dangerously close though, in October 1962, in what became known as the Cuban Missile Crisis.
3 Words in particular can serve as a powerful deterrent to threats arising from speculators. The ECB’s announcement in July 2012, for example, that it is ready to do “whatever it takes to preserve the Euro” is widely credited for having caused a dramatic drop in Eurozone bond yields.
4 Letting Lehman fail was meant as a warning deterrent for large institutions, the message being that reckless risk taking could have serious consequences.
5 This was the largest liquidity injection into the credit market, and the largest monetary policy action in world history.
6 Although there may be no theoretical limit on central bank money printing, the bond purchasing activities of QE does spur an increase in government debt and, in some circumstances, can degrade balance sheet quality of the central bank.
7 The ECB in June of last year joined Denmark, Sweden and Switzerland in charging a negative interest on deposits. 

Currency Wars...

Currency wars are nothing new, the earliest forms date back to the classical ages, when such wars were being waged for the purpose of improving the economic plight of competing nations.

In the pre 19th century era, currency wars played a far less significant role, as “free” trade was rather scarce in a world dominated by mercantilist colonial powers. Monopolies reigned; colonies were frequently banned from trading with rivals and wars were waged through military means as conquest meant control over scarce resources. Controlling resources provided greater self-sufficiency, which in turn resulted in
less of an incentive to trade.

Currency debasements did occur occasionally but the main purpose was directed towards boosting the domestic money supply and increasing the wealth of the authorities1. Rarely was it used as a tool to compete economically. The mercantile-based economies of the time ensured competitive gains mainly through the subsidizing of exports and the imposition of tariffs on imports.

So the world has come a long way from the “gunboat diplomacy” days of the earlier centuries. The change happened gradually as free trade superseded mercantilism. Currencies have become a potent monetary policy tool that can help steer an economy out of trouble but also cause trouble in certain circumstances. For it to work effectively requires agreement and cooperation between trading partners2.

Things can become complicated when several countries are facing similar economic challenges around the same time. Actively weakening a currency can only work if the currency against which it is losing value appreciates in return. When the central banks of several countries actively pursue the depreciation of their respective currencies simultaneously, it is bound to do more harm than good by causing a general decline in trade.

Depreciating a national currency is a potent stimulus weapon mainly because of the speed at which it is able to affect the economy. Think about it, you get almost instant gratification on the current account, as exports of the country suddenly become more competitive3. Large depreciations also have drawbacks in the form of imported inflation.

For countries that have borrowed heavily from abroad, however, a depreciation of the currency will make it more expensive for them to service their debt. This is also why a strengthening currency is an attractive outcome for heavily indebted nations that have a large proportion of their debts denominated in foreign currencies.

Currency depreciation is also a quick and relatively painless way of rendering the labor market of an economy more competitive, something that Eurozone members sorely lack. Their painful alternative has been to cut down nominal wages, which has caused significant negative repercussions on the economy. One of the Eurozone’s major “Achilles heels” stems from sharing a single currency amongst countries with highly divergent economies.

Unlike the U.S. where federal aid and a highly mobile labor market ensure greater regional harmonization, Eurozone members are confined to mainly fiscal means of impacting their economies. The Federal Reserve also has a dual mandate of ensuring price stability and full employment, in contrast to the ECB’s sole official mandate, which is to keep inflation in check.

We are living in precarious times; oil is at record lows, inflation is conspicuously absent and growth keeps sputtering. Many of the high powered stimulus tools have been spent and there is limited visibility on the global economic outlook front. The ECB is about to deploy massive amount of quantitative easing and the Euro has already weakened substantially. A currency war might be brewing, the consequences of which would be nasty.

1 One form of debasement involved reducing the amount of precious metal content in a coin. Through this method, known as Seigniorage, the authorities could collect a tax in return for producing and distributing the currency.
2 In early 2013, for example, G7 members made a joint announcement in which they declared that they would support policy in Japan that would effectively weaken the Yen. The aim was to provide the Japanese economy with enough stimulus to pull it out of a decades long deflationary slump.
3 The effect on exports is not exactly instant and may actually take months. In economics, this is known as the “J-curve” effect in which exporters need time to adjust to the sudden surge in export demand. The short term adjustment is usually through price. 

Feeding On Fear

Just as mushrooms sprout when it rains, structured products have a tendency to blossom during times of crisis. This is not a coincidence, we are talking about instruments that were in certain ways designed to exploit fear.
And what better condition for that than a full-scale market crisis?

Structured products do borrow some of its cues from behavioral finance. Loss aversion and the endowment effect are two well-established psychological biases that tend to kick in when things turn sour. Take the basic notion of loss as an example. Nobody likes to lose, whatever the circumstances. Studies show that the sensation of pain to a loss is roughly double in size to the pleasure effect we obtain from a gain of similar magnitude1. No wonder we hate to lose!

As for the endowment effect, it has to do with our dislike for moving out of the “status quo”. We prefer to stick to our “comfort zone” than change to something else. The uncertainty that “change” engenders is perceived as a risk, which explains our dislike for it.

Structured products somewhat exploit these two biases in addition to a third one known as “framing”. Framing has to do with the manner in which a choice is presented to someone2. Due to our cognitive biases, our decision on what option to choose from is very much dependent on the way it has been presented to us.

On October 6 of this year, a well-established financial firm that I will not name issued a structured note linked to a broad and popular stock index. The condition stipulated that if the return on the index was anywhere within a maximum loss of 15% and a maximum gain of 25% by maturity (which is in January 2017), the investor will cash in a 21% return. If, on the other hand, the performance of the index ended somewhere beyond those limits, the investor would only get the principal back3.

Now let us analyze this note in context to the biases mentioned earlier. With regard to the “framing” cognitive bias, it is interesting to note that this product was issued at a time when market volatility was rising sharply, creating an environment of uncertainty and fear. Offering a note where the worst outcome would be that you get your initial investment back is an attractive proposition when sentiment turns to fear.

The next interesting aspect of the way this note has been structured has to do with the price triggering limits. Notice that the gain-triggering limit at 25% is more than the loss- triggering limit of 15%. It is a classic play on the “loss aversion” bias but also misleading because gains are in fact canceled if either limit is breached. Inverting the price limits (i.e. 25% on the downside and 15% on the upside) would make it a more attractive proposition but the issuer seems to think that framing it with the loss aversion bias in mind would make it more attractive4 to the buyer.

Last but not least comes the endowment effect. Take the case of an investor that has made considerable gains from the stock market right before a market crisis erupts. That investor may wish to lock in those gains over a long enough time horizon for the “storm” to subside, but without staying completely out of the markets. They are concerned by the surge in volatility and don’t want to risk venturing too much out of their “comfort zone”5.

Similarly for the investor who experiences major losses following a market correction and wishes to limit any further losses going forward. The instrument gives them a chance to gain substantial returns within a time frame and also provides a cushion in the event that things turn really nasty. 

All this is good and structured products certainly do have their place, but caveats abound. For one, these complex and opaque instruments carry substantial fees that the investors are typically unaware of, making them extremely profitable to issuers. More importantly, in certain adverse market conditions, the investor risks losses that go beyond the contractual promises of the instrument6. Food for thought...

1 Kahneman, D. and Tversky, A. (1984). "Choices, Values, and Frames". American Psychologist 
2 Tversky, Amos; Kahneman, Daniel (1981). "The Framing of decisions and the psychology of choice".
3 It should be noted that only the principal or original investment is returned to the purchaser of this instrument, excluding dividend payments and/or interest. In the event that the limits are breached, and only the principal is returned, the investor will end up worse off than if he or she had bought a treasury type bond with the same maturity instead.
4 Clearly the triggering price limit settings are also influenced and constrained by option pricing and the aim of maximizing profitability for the issuer.
5 In this example, the “comfort zone” has been established by a protracted period of low market volatility. The change in volatility is what is triggering a move out of this “comfort zone”. 

The "Thought" Virus...

We are all creatures of expectations. We incessantly try to measure, evaluate, and gauge the probable future consequences of our actions of today and in the past. Even if the results of our attempts in forecasting are often less than satisfactory, it certainly doesn’t seem to discourage us from trying again.

It is as if ingrained in us, hardwired to our brains and most likely inherited from our ancestors from long ago. Ancestors that very much depended on being able to anticipate the near term with enough precision to survive a rapidly evolving and inhospitable environment. That habitat is no more[1], but our desire to anticipate remains.

Right now, one of the world’s major preoccupations is the Ebola virus, a horrible hemorrhagic fever that seems to be spreading like wildfire. What was merely a footnote is now front page headlines. Governments are waking up, pharmaceuticals are concocting experimental drugs and markets have been shunning airline stocks[2]. That last observation about airline stocks is an interesting one, as it seems to be entirely driven by a sort of narrative.

That narrative goes something like this: The Ebola virus is spreading exponentially, it may soon get out of control and may eventually threaten our very existence. Really? How did we get from very local to global threat? The clues may lie in the uncertainties built into the narrative.

We don’t know, for example, if the Ebola virus could eventually mutate into a more “virulent” and deadly form. We don’t know if we will develop the technological means in time to put an end to it and we don’t know whether it may just plateau on its own and subside from there on (like many epidemics seem to have done before it).

 It just happens to be that uncertainty fuels the narrative, which in turn amplifies that “uncertainty” effect. This “negative feedback loop” is the basic mechanism by which rational becomes irrational and order switches to panic.

The markets have been infected by a “thought” virus, spreading through contagion just like a real disease would. When you combine our need to decipher the future with a potential threat in that future, and dose it with enough uncertainty, the result is frequently trouble. The uncertainty acts as the lubricant that helps spread the “thought” virus.

Markets, perhaps unsurprisingly, function similarly, with movements and trends being influenced in large part by a collective “narrative” of the participants. The recent spike in volatilities is a case in point, symptomatic of a narrative-based “thought” virus contagion. Until recently the consensus narrative has been one of slow but steady global economic healing spurred by an extended period of heavy handed central bank intervention in capital markets.

Businesses have also contributed to this by nurturing an overly upbeat sentiment. Corporate earnings have remained strong over a long stretch, thanks to a combination of cheap borrowing, low wages and healthy export demand. This, in turn boosted stocks, fuelling a “positive feedback loop” that remained despite the protracted period of weak growth, high unemployment and deep structural deficiencies.

The narrative went probably something like this: the authorities are firmly in control, inflation is tamed, markets are calm and corporate earnings couldn’t be healthier. Investors were also under peer pressure to perform in a low-volatility, bull market environment. Governments cranked up that pressure by significantly raising the cost of staying on the sidelines[3].

The previous narratives of “new normal / ring of fire” around the time of the Greek sovereign bond crisis in 2010 was put on hold. That changed as new threats began to appear on the horizon[4], tipping the balance towards a newly minted “secular stagnation” thought virus. The ensuing spike in volatilities reflects the growing uncertainties that the new worries carry.

So, in effect, there hasn’t been much of a real change on the ground. The global economy was stuck in a “new normal”, lower secular growth all along, and that narrative is starting to sink in again[5]. To make matters worse, many of the problems that brought us here in the first place have not been resolved. From the urgent need for banking reform in the Eurozone to the global impact of a maturing economy in China, the troubles will endure. That is until a new “thought virus” sway markets in another direction.

---

[1] Through our superior intelligence we have succeeded in taming our habitat, eliminating most of the natural threats but also introducing new ones in the form of damage to the environment.

[2] Airline stocks are being battered as the market is anticipating earnings losses resulting from travel being hindered if the Ebola virus continues to spread. This is a good example of psychologically induced trading with uncertainty pushing sentiment towards irrationality.

[3] Most notably by bailing out troubled firms and institutions, instead of letting them fail (instilling a moral hazard mindset) and through a generous amount of quantitative easing activity over an extended period. One side effect of this is the growing complacency that has also contributed in fueling the bull market.

[4] The emergence of Ebola as a global threat, geopolitical tensions in the caucuses and Middle East, deflationary risk in Europe, Hong Kong protests and further signs of economic slowdown in China have all contributed to the formation of a new “secular stagnation” narrative.

[5] “Secular stagnation” is in fact a worse condition than “new normal” as it threatens the global economy with another bout of recessions. In that sense we could argue that it is a different narrative to that of the “new normal” but also a possible consequence of it.