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.