Bloomberg: Risk-free Assets are the New Tail Risk
Wednesday, 5 July 2017
In his theory on financial markets’ fragility and instability, the late Hyman Minsky argued that “from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control.” Following the 2008 crisis, he inspired the term “Minsky moment” to describe a sudden market collapse that follows the exhaustion of credit.
Today, we may be approaching a second Minsky moment. After the 2008 debt crisis, central bankers reacted with unconventional tools. If the problem was excess debt, the remedy applied was to lower interest rates and buy large quantities of it. Quantitative easing helped to avoid an even deeper recession, but it didn’t solve the root causes of the crisis. Global debt levels are up 276 percent in the last decade to $217 trillion, or 327 percent of GDP, according to the Institute of International Finance.
But this time around the issue isn’t only excess debt — it is also that prolonged loose monetary policy may have left us with at least three collateral effects.
The first is a misallocation of economic resources. By keeping rates at record-low levels, central banks have made it easier for inefficient firms to survive, as in a rising tide that lifts all boats. The second is a rise in wealth inequality, where the wealth effect from rising asset prices benefited asset owners and the old more than the young and the poor. The third is a suppression of risk premia and volatility across financial markets.
The existence of zombie companies and banks can lead to lower economic productivity over time, leaving debt overhangs and overcapacity in various sectors. Energy in the U.S., mining in Australia, heavy industry in China and banks in Europe are some examples. A recent European Central Bank paper shows that inefficient allocation of credit by banks is a key factor in reducing productivity. Higher inequality has arguably had a strong role in the rise of protest votes in the U.S., U.K. and Europe, leading to a range of nationalist and protectionist policies. Higher inequality alone as well as these policies can hurt growth, as an International Monetary Fund paper argued in 2014. But the biggest worry for investors is that the calm environment established by QE may conceal a storm, and that such extraordinary measures may have encouraged the formation of asset bubbles ready to pop when loose monetary policy ends.
Unlike in 2008, the culprit isn’t low-quality subprime mortgage debt, but sovereign bond markets. Central bank purchases of government paper reduce yields and volatility. In turn, this pushes investors to search for yield in other markets, such as investment-grade and high-yield bonds. This search for yield lowers funding costs for firms, but also risk premia associated with default risk and credit volatility. The next step for investors is to turn to other means to achieve yield, selling volatility for example. Over the years following the crisis, short volatility strategies have flourished, gathering record sums of assets under management. Similarly, credit spreads and implied volatility from option premia in equities, rates and currencies are at or near record lows.
The anticipation of more stimulus also changed investor behavior, in that they became eager to take on more risk, or buy the dips, knowing that central banks would keep QE measures going at the first sign of market turbulence. While in theory central bankers should not base their policy decisions on financial market developments, a sharp rise in volatility could lead to an excessive tightening in financial conditions, threatening their inflation targets. This interdependence contributed to the ECB’s dovish tone before this year’s French elections and around uncertainty over the Italian elections.
Many have been calling for an end to this low-volatility, buy-the-dip environment but have largely failed — perhaps, until now. Although central bankers’ main worry since the crisis was to stimulate the economy and financial markets, their tone has recently shifted. With the U.S. reaching full employment and European growth data breaking multi-year highs, the Federal Reserve, which had already signaled a move toward policy normalization, together with the ECB, Bank of Japan, Bank of England and Bank of Canada all more forcefully expressed a hawkish stance.
Investors reacted with a sharp sell-off in government debt, marking the worst day in German bunds since 2015. The shockwave reverberated through other markets, including equities and currencies, and hurt short volatility and risk-parity strategies, which are based on a stable correlation between risky and risk-free assets, such as government bonds.
The recent turmoil offers a good example of what’s to come as the global economy recovers and central bankers curb stimulus. The situation is somewhat of a Catch-22 for central bankers. Withdrawing stimulus may result into a return of volatility and perhaps a crisis today, while keeping it going may create an even bigger one tomorrow. Sooner or later, volatility will rise again. When it does, the tail risk may come from “risk-free” assets.
One year after the start of the crisis in 2008, Fed Chair Janet Yellen delivered a speech at the Levy Economics Institute, where Minsky was a scholar. The topic was how to prevent future meltdowns, with capital controls, liquidity requirements and macro-prudential supervision some of the suggested fixes. She noted an irony: her previous speech at the institute, in 1996, was on measuring risk with complex instruments such as securitizations. “I remain highly optimistic that both our system of financial intermediation and our system of financial regulation will remain strong and resilient,” she said at the time.
Nine years after the crisis, regulators have tightened capital and liquidity requirements. Yet central banks continue to encourage investors to buy dips and sell volatility as part of the wealth effect and portfolio rebalancing channels of QE stimulus. Financial stability oversight and macro-prudential policy remain a side game, generally outside their core mandate. Last week, Yellen went even further, saying a financial crisis is unlikely to happen in our lifetimes. If he were alive, Minsky would be shaking his head.
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