Vicious Vortex

When interest rates are reduced speculative money from developed markets flows 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 and a laissez-faire attitude reigns supreme. It is also borne out by the very low readings of the VIX index which measures market volatility. While it peaks at levels around 40 during times of panic, it is currently close to just 10. The index shows the urgency to buy protection against the stock market in the form of put options and is currently very subdued. While US interest rates have risen 15 times to 4.75%, investors are not heeding the warning that this is a bad thing. Apart from worsening America’s deficits and increasing the likelihood of a burst bubble in the property market, it is also unhealthy for markets. The centrifugal action of a vortex drags objects 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 are cruising the neighbourhood for more action; 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 thinks this is the stuff of theory, then one need only look at what happened recently with Icelandic bonds. In the last two months, US$ investors have lost 25% of their money. It should come as no surprise given that Iceland has issued vast amounts of foreign-owned bonds which mature over the next year. Their value is close to that of the entire economy and it is hard to see how overseas investors will buy such instruments without significantly higher yields. As for Dubai, the stock market has halved in local currency terms since November 2005. Markets no longer operate in a vacuum and, if anything, it is the action on the periphery that sparks off something worse in larger markets. This was the case with the 1997 Asian crisis which started its freefall when the tiny market of Thailand hit the buffers.

Stock market upturns tend to act in three stages with a liquidity-driven first phase, followed by a mid-cycle correction and finishing with an earnings-driven rally. It appears that we have been through all three. Given that the average trough to peak in US markets is 33 months since 1937, then the current rally of 41 months is really pushing the limits. There is also the classic 4-year cycle of market sell-offs which implies there is a troubled autumn in store for 2006. While some pundits are suggesting that companies will carry the baton for the flagging consumer, I am a little sceptical. First, consumers make up 70% of US economic activity. There would have to be a capital expenditure programme of immense proportions to take up the slack in demand. Second, Western companies have learned their lesson from the 1990s and are not investing heavily in plant or people as this can be outsourced overseas. While they are using cash piles to take over other companies, one should not use heightened M&A as an indicator of good times ahead. If anything it is a classic top-of-the-market activity.

The lines of global politics are rather like the seven tectonic plates that make up the crazy paving of the earth’s outer crust. The boundaries may bump and grind from time to time but on the whole they are relatively stable and slow moving. Occasionally the pressure built-up is simply too great such that a major earthquake or dislocation occurs. This happened with the Boxing Day 2004 Tsunami which originated in the Indian Ocean. As one side of the seabed unzipped and rose up 15 metres, the ocean was literally tipped forward in a 1200 kilometre front, creating a wave of devastating strength and speed. To extend the analogy to the political level, the September 2001 terrorist attacks caused the first crack in the fault line. The US economy had already been emasculated by the crash in technology stocks in 2000 so the 9/11 attacks appeared to be the coup de grace. A mood of ‘No Surrender’ enveloped America, as the Stars and Stripes appeared to flutter from every flagpole and SUV aerial. An economic slowdown was politically not an option and any talk of recession was deemed to be disloyal.

The slashing of interest rates thereafter, coupled with the huge stimulation through tax cuts and government spending have now caused an irreparable fracture in America’s finances. Like the earthquake below the ocean surface, these ruptures are not initially visible but will soon be felt with full force. Like the Tsunami, they will arrive in a series of relentless pulses, or waves that will batter the global economy. Before the first wave struck in Asia, two mysterious phenomena occurred. First, the animals disappeared as they instinctively ran for higher ground. Second, the shore-line retracted for hundreds of metres, leaving many fish flapping on the sand. Curious onlookers were tragically drawn in and stumbled straight into the path of the oncoming water wall. This warning sign bears a remarkable resemblance to two areas that must now be avoided. The first is the recent upturn in the property market and the second is the strength of the dollar seen in 2005. These twin traps are drawing investors back to the danger zone just when they should be running for cover in the opposite direction.

Steady but subtle alliances are being drawn up between developing countries, (Brazil, Russia, India and China), America is still behaving as though there will never be a competing Superpower. The core of American hegemony is the US dollar and this is under threat. The creation of more debt in the new millennia than all previous presidents put together since George Washington is the surest indication that American government spending is out of control. It would not take much to prod this debt-ridden country into crisis. The catalyst could be simple – such as pricing oil in Euros as suggested by Iran. Or it could be more complex as developing countries take umbrage at being told what to do and stop buying the blizzard of US bonds. Either way it is the reaction that never changes in such situations; weaker currencies, rising interest rates, property declines and then a severe recession. Let us hope that this never comes to pass as dollar devaluation would not be a pretty event as it would send food and energy prices surging. In such circumstances gold would be one of the few safe-havens for investors. But if America keeps printing money and waving a big political stick then they will have no one to blame but themselves for their future misfortune.

Toby Birch
March 2006