Measure for measure - by Buttonwood

Buttonwood

Measure for measure

Mar 23rd 2005
From The Economist Global Agenda
Source

Bond investors are becoming increasingly rattled by trifles. Does this imply a crisis, the “measured” return of rational pricing, or neither?


BUTTONWOOD is not the only one who considers General Motors the slowest-moving car crash in history: the bonds of this former blue chip have been trading like junk for a while. Yet its profits warning last week prompted sell-offs in virtually every risky asset there is, and even in some not-so-risky ones. The spread (ie, risk premium demanded by investors) of high-yield debt over Treasury bonds widened by 20 basis points. Mutual funds investing in the bonds of emerging markets, darlings of the year to date, saw net inflows fall to a quarter of the previous week's figure and high-flying Brazil had to suspend its weekly sale of bonds. The VIX volatility index for equities, dozing for ages, moved higher.

So it went again this week. Despite virtually everyone expecting the Federal Reserve to raise short-term interest rates by 25 basis points to 2.75% on Tuesday March 22nd, and to give the usual prediction that future rate rises would be “measured”, the markets were paralysed for three days beforehand. The Fed duly did what it had signalled it would do, and the relief in the markets was palpable. However, its statement was seen as being slightly more hawkish on inflation than the last one, sending bond and share prices down a bit.

All this has prompted speculation that the bond market is on the turn. Actually, it turned two years ago, when the yield on the ten-year Treasury benchmark bottomed out at 3%. But it is interesting that the sell-off of riskier assets is taking place against the background of reasonably robust economic growth, apparently contained inflation and no truly new news. Why is everyone so nervous?

For two reasons, mainly. The first is that bonds are badly mispriced—ie, yields are too low and spreads too narrow to compensate investors for the risks they are taking—and most people suspect that a correction is imminent. True, company balance sheets and cash positions are stronger than they were two or three years ago, but they are nowhere near as solid as they were in 1996-97, the last time that corporate spreads were as narrow as they are now, points out John Lonski, chief economist at Moody’s Investors Service, a credit-rating agency. And though many emerging countries are stronger financially and better managed than they were, a favourable world economic environment has something to do with both this and the recovery in corporate balance sheets.

The second reason why investors are jittery is that though the economic news is broadly plausible on its face, there is widespread worry about semi-submerged inflationary pressures (oil above $55 a barrel, other commodities on the rampage, and a weak dollar stoking rising prices for imported goods). Less widespread but lurking is concern that the need to finance huge trade and budget deficits is transferring wealth to investors outside America. Both worries converge in a greater one: that they will help to make higher—perhaps sharply higher—interest rates inevitable. Sharply higher rates would knock the socks off those assets that relied on excess liquidity for their popularity (eg, most junk and emerging-market bonds) and also threaten financial-sector profits and the consumer spending that has powered economic growth.

Why is risk so mispriced? A lot of the responsibility rests on the Fed’s shoulders. The decision to cut interest rates sharply in order to prevent recession after the dotcom bubble burst flooded the market with liquidity. The Fed’s policy of telegraphing its future intentions to even the deafest listener has enabled one-way bets. And the official arm-twisting that persuaded Wall Street’s primary dealers to mop up after Long Term Capital Management, a hedge fund that went spectacularly bust in 1998, has contributed to what Alan Greenspan, the Fed’s chairman, calls “complacency” and James Bianco, of Bianco Research, terms “a gigantic moral-hazard market”. With mainstream returns low, investors have been willing to seek even mildly higher yields in risky pastures, on the unspoken assumption that Uncle Alan will keep the worst unpleasantness at bay.

But there is more to it than that. The Fed has been genuinely puzzled that long-term interest rates have failed to move up in line with its hikes in short-term rates. The yield on ten-year Treasuries has actually fallen since the Fed started raising rates. Monetary policy has, in a sense, been running to stand still.

Never mind the price

Part of the puzzle is that there are now various sorts of buyers in the market for long-dated bonds who are simply not price-sensitive. Among them, as is well known, are foreign central banks, mainly Asian, who buy dollar-denominated securities for reasons other than return. Their goal is to recycle trade surpluses and prevent their own currencies from strengthening against the dollar.

Another group of price-insensitive buyers, more controversially, are western pension funds and life insurers. Anatole Kaletsky, an economist with the consulting firm GaveKal, argues that regulatory and accounting pressures are changing the core competence of pension funds from asset management focused on maximising returns to liability management focused on almost robotically matching assets and liabilities. This is one reason for the recent shift into bonds—especially long bonds—from equities in both Britain and America. Similarly, life insurers, who used to make a living selling equity-based investment products, especially in Britain, are more curtailed now as to what they can invest in. Since it is harder now to derive competitive advantage from investing more intelligently than their rivals, they are concentrating on traditional, play-it-safe life cover and heavily buying bonds.

A third group is harder to identify but increasingly important: private overseas buyers, especially Japanese. In 2004, for example, foreign private buyers directly or indirectly bought American securities worth three times as much as official buyers did. They snap up anything dollar-denominated that moves because interest rates in Japan itself are so low. The buyers risk losing money if the dollar weakens but many want to hold the securities to maturity for their higher yield anyway. There is a bustling business in “annuity arbitrage” based on the difference between Japanese and American interest rates.

All this seems to indicate that though there has been a move in America’s bond markets toward requiring higher yields for higher risks, the process is likely to be slower and less disruptive than might have been the case—at least until Japan’s interest rates rise significantly or its private investors find attractive alternatives to American assets. That is good news in one way but bad in another. If yields rise only slowly, then inflation will continue to neutralise monetary tightening, inflationary pressures will continue, so will fiscal indiscipline, and price bubbles will keep on rolling from one asset class to another. Reason enough, perhaps, for investors to keep getting their knickers in a twist.




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