Tuesday, May 18, 2004

Monetary Policy: Systemic Risk from interest rate: Where?

Brad Delong discusses the WSJ article on systemic risk in the marketplace to interest rate increases.

Henny Sender of the Wall Street Journal writes about the potential for systemic risk when interest rates rise. He focuses on hedge funds--but that's the wrong category to look at. He needs to figure out who (a) is highly leveraged and (b) has placed big bets that interest rates will remain low and smooth. There's where the danger will come from. LTCM was not a typical hedge fund

This is his second article on the topic.

When interest rates rise, the gap between the interest rates people pay on their mortgages and market rates increases--lowering the market value of owning a mortgage--and the amount of time people will hang onto their low-fixed-rate mortgages lengthens--further lowering the market value of owning a mortgage. The values of mortgage-backed securities are very sensitive to changes in interest rates.

What is most interesting, perhaps, is that there are people at CSFB who are willing to assert that BofA, J.P. Morgan Chase, and Citigroup have large unhedged exposures to interest rate risk.

For the oldman's opinion the systemic risks this time may come from normally considered very safe money market funds and other institutions that have used derivatives to bolster their returns in an otherwise low-interest rate environment. The more greedy ones will have overextended and even with all the ample Federal Reserve forewarnings may have made bets that have yet to be unwinded. In addition the junk bond market has been keeping afloat some very chancy companies and with a rise in interest rates, these equities will probably feel the bottom fall out rather quickly. Finally Fannie Mae and co. are probably massively over-extended.

So there's three major players for ya.

International bond-markets have also been feeling hard hit by the imminent rise in interest rates. The Economist reports on this trend that is occuring because as American interest rates increase the emerging markets will also have to increase their rates to continue to attract more foreign investment capital.

Markets everywhere have fallen as the day nears when the Federal Reserve raises rates. Hardest hit have been emerging-market bonds

APART from citizens of Brazil and the rarefied folk that deal in international bonds, few will have heard of, much less care about, that country's dollar-denominated 11% bond, which matures on August 17th 2040. In fact, it is rather important. Since this is the country's benchmark bond and Brazil is the biggest debtor among emerging countries, it has become the benchmark bond for all emerging markets. Even by the exacting standards of such markets, Brazil's 11% '40 is stomach-churningly volatile. As a much-favoured play for investors fleeing small yields on American Treasuries, the price of the bond rose from 43 cents per dollar of face value in late 2002 to 120 cents in January, dragging yields from 26.7% to 9.5%. Since then the bond's price has fallen by 30% or so, and this week touched a low of 83 cents.

On top of domestic wobbles, the proximate cause of this latest fall in the Brazilian benchmark were worries that, as result of a series of strong economic statistics from America—the latest being robust employment numbers—and inflationary stirrings, the Federal Reserve will put up interest rates much sooner than the market had expected. It now thinks they will rise in June. The yield on ten-year Treasury bonds, which had fallen to 3.65% in March, climbed at one point this week to 4.8%.

Though extreme, the reaction of the Treasury-bond market (and other bond markets) to the threat of higher interest rates and creeping inflation was predictable enough. Less predictable, perhaps, has been the sharp fall in the price of riskier assets the world over.

Investors' biggest worry is that a rise in American rates will withdraw a crucial support from the many markets around the world that had risen vertiginously, helped up by the many who had wanted more bang for their buck than could be gained from popping it in the bank. Their fears have been doubled because many of these, hedge funds being the most obvious, had taken advantage of ultra-cheap borrowing to leverage these bets.

Betting with borrowed money worries many because, although it allows investors to make more when markets go their way, it multiplies their losses when they do not. Enforced liquidation—or the fear of it—has been partly responsible for markets' skid in recent weeks
. That, after all, was what happened in 1994 when the Fed last raised rates sharply. And in 1998, Russia's default led to the near-collapse of Long-Term Capital Management, a hugely leveraged hedge fund, and caused huge losses for other leveraged investors.

These fears have been the main reason why stockmarkets have fallen lately—although spurting oil prices (see article) also frightened investors this week. America's S&P 500 is now down 5% from its recent high. European shares, too, have stumbled: the Eurotop 300, an index of the shares of leading companies, is 5.5% off its peak. Japan's Topix index, which had been driven up entirely by foreign buying in recent months (domestic investors have been selling all the way up) is now 8% below its high; on May 10th alone, it fell by almost 6%, before perking up later in the week.

These falls pale, however, when compared with those in emerging markets. An index of emerging-market shares compared by Morgan Stanley Capital International has fallen by about 16% from its peak in mid-April. In part, these woes reflect fears that China's demand for commodities, and hence commodity prices, will falter. If this happens, economies that rely on commodity exports will suffer. Stockmarkets in countries where interest-rate and commodity-price fears are combined, as they are in Latin America, have done especially badly. Argentina's and Brazil's are both down by a quarter from their highs.

And then there is emerging-market debt. As a uniquely poisonous cocktail, mixing fears of rising rates with high leverage and silly valuations, the market for such bonds is hard to beat. Last year, investors, especially leveraged ones, piled into emerging-market bonds as a splendid way to pick up yield. But as worries that rates will rise have mounted, a fall over the past few months has turned into a rout as the hot money has scrabbled to get out. [emphasis added]

I don't think that emerging markets in Asia will take a big dive because of the situation. Their equity markets are already due for a cool-down in Asia. (The Economist) However the emerging economies of South America may have a difficult time indeed, with countries like Argentina, Brazil, and Turkey once more moving into the spotlight of financial infamy.

The only real advantage is that the Fed has been behind the curve and has telegraphed its actions greatly. The systemic risk is probably going to be the China & Hong Kong axis along with the potentially overextended US Treasury position of the BOJ (Bank of Japan). These issues I'll deal with tomorrow as promised on my China economic analysis post that will link up where the 'price of oil' article left off.


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