Page 4 of
5 THE INTEREST
RATE CONUNDRUM, Part 2 How currency devaluation
destroys wealth By
Henry C K Liu
took place
over a three-to-six-month period, followed by a
period of stabilization that lasted about three
months and a recovery period that took place over
a three-to-12-month period.
But were these
real recoveries, or were they merely the
stabilization of uneven currency devaluation?
Could it be that the
dollar never did recover, but
other currencies finally caught up with the
dollar's collapse? Dollar interest rates were not
rising at a pace demanded by its fall in real
purchasing power.
More lessons in
1998 The 1998 credit-spread crisis shares a
number of similar features with the 1994
bond-market crisis.
As in the 1994 crisis,
fund managers in 1998 once again took on
aggressive highly leveraged long positions, this
time in spread products, evidently believing that
credit spreads would continue to narrow.
Unfortunately, Russia's decision on August 26,
1998, to engineer a controlled default on its debt
obligations led to a complete reassessment of
credit risk by global investors. The herd-like
rush to exit caused the collapse of the hedge fund
LTCM.
Fear that default risk might
increase and spread worldwide led to a mad
scramble for liquidity. Quality spreads in the US
corporate bond market widened dramatically and
stood at recession levels. Indeed, the yield
spread between Baa corporate bonds and US
Treasuries widened to levels not seen since the
1990-91 recession. US corporations became less
willing to borrow and therefore curtailed
investment spending, which clearly dampened US
growth in subsequent years.
High-yield
spreads are tied to fundamentals such as expected
future default rates. But spreads are also related
to market liquidity in ways that are not yet well
understood even by the most seasoned
professionals.
Liquidity can disappear
quickly Liquidity, a fundamental concept
relating to the quantity of money in monetary
policy, can also be defined in the market as the
ability to buy or sell large quantities of assets
quickly and at low discount and cost.
Normally liquid assets can become illiquid
in a market meltdown. The vast majority of
equilibrium asset pricing models do not consider
the effect of trading and thus ignore the time and
cost of transforming financial assets into cash or
vice versa, particularly in times of distress or
exuberance, rational or irrational. Recent
financial crises, however, suggest that, at times,
market conditions can become suddenly severe and
liquidity can decline or even disappear extremely
quickly, even overnight or even in the middle of a
trading day. Such liquidity shocks are a potential
channel through which asset prices are influenced,
or distorted, by liquidity.
In 1994, the
bond market was caught on the wrong side of
economic fundamentals and yanked down with the
shifting tide of higher rates at the Fed. But
stocks skated through relatively unscathed,
because credit was still available and investors
recognized that the bond market needed an
adjustment that more accurately reflected the
central bank's new thinking.
A bond fund's
"duration" measures the theoretical impact that
one percentage-point rise in interest rates would
have on the net asset value of a fund. A bond fund
with five-year "duration" could be expected to
drop by 5% in value if interest rates rose by 1
percentage point. Conversely, a 1-percentage-point
drop in rates would cause a fund with five-year
duration to increase by 5% in value.
To
figure total return, changes to net asset value
(NAV) should be added or subtracted from the
income generated by the fund. So a bond portfolio
with a 3% yield whose NAV drops 5% would suffer a
loss of 2% on a total return basis over a 12-month
period.
Long-term bond funds often have
effective durations of at least seven years. In
that case, a rise in long-term interest rates of 2
percentage points over the next 12 months would
cause at least a 14% drop in value. With yields on
long-term Treasury bonds at 5%, such an increase
would translate into a loss of 9% or more for fund
shareholders - similar to when the Fed tightened
monetary policy in 1994.
To protect
against that possibility, investors keep
fixed-income money in short-term corporate bonds,
typically with durations of six months or less.
With yields of long bonds below 5%, it would take
a 9-percentage-point boost in short-term interest
rates just to push the total return on such funds
into the red over a one-year period. In the
current environment of massive overcapacity and
debt, the chances of that happening are about
zero. That is why long bonds will rise as surely
as tomorrow's sun.
The lessons of
2003 In July 2003, Federal Reserve
officials engaged in damage control after
Greenspan spooked the bond market in congressional
testimony by suggesting that the FFR at 1% might
have fallen as low as it would go. Greenspan
further disappointed investors by noting that the
Fed was unlikely to engage in "unconventional"
market activities, such as buying long-term
government bonds to drive down long-term rates,
which had stayed inverted for extended periods.
The policy of using interest-rate cuts to
pump up demand has been tested to destruction
since 1994. But all policies carry costs. The
costs in this case included most obviously the
dangers of pushing down long-term interest rates
as well as short-term to a level that might be
unsustainable, and subsequently reigniting
inflationary pressures. In other words, the
Federal Reserve was creating a bond bubble similar
to the equity bubble, and then protecting the
equity bubble by creating conditions where that
bond bubble would be popped.
But investors
that anticipated this scenario were fooled.
Long-term rates stayed low because massive capital
inflow came from foreign central banks operating
under dollar hegemony. Bonds rose in 1994 further
and faster than at any stage in the previous four
decades, and collapsed in 1996 and again in 2003.
Once market participants think the market
is turning against bonds through a rise in
interest rates, they are likely to stampede out of
bonds, creating a bond crash similar to the equity
crash. Traders hedge their risk exposure in bonds
with compensating positions in interest-rate
futures by adopting immunization strategies by
constantly rebalancing price risk with coupon
reinvestment risk, which change in opposite
directions.
In the 1950s, the bond market
was considered a safe, conservative investment. At
that time a buy-and-hold strategy was sufficient.
However, since the 1960s, inflation has increased,
and interest rates have become more volatile.
Thus, with more volatile interest rates, there
exists a greater profit potential with bonds.
Also, the Macaulay duration, named after Frederick
Macaulay, the introducer of the concept, being the
weighted average maturity of a bond where the
weights are the relative discounted cash flows in
each period, came into use in the 1970s.
Under conditions of a liquidity boom,
rising rates lower bond prices as well as equity
prices. That combination is explosive enough, but
adding to it the impotence of rising interest
rates to halt the declining value of the dollar,
we have a mixture of deadly financial dynamite
that can be detonated by seemingly unrelated minor
developments at unexpected times.
The
psychosocial effect of a bond crash on market
sentiment is highly damaging. Market participants
and investors have been conditioned to think that
lower returns on bonds are justified by their
being less risky than equities. On a 30-year or
longer basis, this is a correct view, but not on a
three- or five-year term. Under current market
conditions, there exists at least as large a
possibility of 10-year bonds falling by 25% over
any 18 months as there is of shares falling by the
same amount. Yet investors in bonds do not have
that same awareness of risk as equity investors,
so the consequences could be serious. A typical
portfolio with one-third in bonds will not escape
losses in a bear market.
Total return
swaps Total return swaps (TRS) can make
short-term dollar loans (liabilities) appear as
portfolio investments. Also, the requirement to
meet margin or collateral calls on derivatives may
generate sudden, large foreign-exchange flows that
would not be indicated by the amount of foreign
debt and securities in a nation's
balance-of-payments accounts. As a result, the
balance-of-payments accounts no longer serve as
well to assess country risk.
Even for the
dollar, which is protected by dollar hegemony in
which the United States can print more dollars at
will, the long-term consequences of currency
devaluation will cause structural damage to both
the economy and investors. In the event of
currency devaluation or a sharp downturn in
securities prices, derivatives such as
foreign-exchange forwards and swaps and TRS
functioned to quicken the pace and deepen the
impact of the crisis.
Derivatives
transactions with emerging-market financial
institutions generally involve strict collateral
or margin requirements. Asian firms swapping the
TRS on a local security against LIBOR (London
Inter-bank Offer Rate) post US dollars or Treasury
securities as collateral; the rate of
collateralization is estimated at about 20% of the
national principal of the swap. If the market
value of the swap position were to decline, then
East Asian firms would have to add to their
collateral to bring it up required maintenance
level.
Thus a sharp fall in the price of
the underlying security, such as would occur at
the beginning of a currency devaluation or broader
financial crisis, would require Asian firms
immediately to add dollar assets to their
collateral in proportion to the loss in the
present value of their swap position. This would
trigger an
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