Toby Birch

Articles:

Vicious Vortex

By Toby Birch March 2006 TTG

When interest rates are reduced it has the equivalent effect of jumping on a water bed. Liquid is forced into every corner and the bed begins to strain at the seams. In a similar manner, speculative money from developed markets tends to flow overseas and into ever-riskier instruments as the cost of borrowing decreases. By the time that US interest rates had begun to rise from their ridiculous levels of just 1% in 2004, a whole myriad of investors had already embarked on a feeding frenzy. It trebled some emerging markets, such as India, in the space of just a few short years. The ballooning hedge fund industry also took advantage of these Bacchanalian conditions by borrowing to the hilt in low yielding dollars and buying the high yielding debt of developing countries. A good time was had by all and the unsustainable environment led to a tasty $20 billion of Wall Street bonuses in 2005.

We now see that yield difference between risky emerging market debt and supposedly-safe US Treasuries is back to record lows of just 2%. This implies that there is a good deal of appetite for risk such that a laissez-faire attitude reigns supreme. It is also borne out by the very low readings of the VIX index. While it peaks at levels around 40 during times of panic, it is currently close to just 10. The index is a measure of volatility that shows the urgency to buy protection against the stock market in the form of put options is very subdued. While US interest rates have risen 15 times to 4.75%, investors are not heading the warning that this is a bad thing. Apart from worsening Americs deficits and increasing the likelihood of a burst bubble in the property market, it is also unhealthy for stock markets. The centrifugal action of a vortex drags everything around it into its centre. A similar effect is observed in stock markets. As rates rise, liquidity is sucked out of the market and the yield curve begins to invert. This is where the return on cash is better than that on riskier bonds. Investors then begin to resemble frightened snails that withdraw into their shell. Why jeopardise one's wealth with risky assets when there is a nice, safe return in cash? The last time the yield curve inverted was in 2000, just before the bear market. In those days no one cared about boring bonds because their actions did not fit in with the supposedly new paradigm of technology stocks.

We now have a new breed of speculators whose living depends on cheap borrowing. Instead of taking the hint from US rate rises that the party is over, they have instead gone wondering around the neighbourhood for more action. They are now borrowing in hard currencies such as the Swiss Franc to fund the next frenzy. Markets are full of warning signs for those who are humble enough to listen or look for them. The straightforward message they tell us is that a low yield is reflective of low levels of risk and government debt. As ever, we return to the never-ending relationship that risk and reward are proportional. By borrowing (or going short of) a low yielding currency, one will make significant losses if the proceeds are used to buy a high yielding currency which subsequently devalues. Just in case anybody

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