INSIGHTS / Silver Bullet
The Silver Bullet | Is the World Running Out of Safe Havens?
Wednesday, 28 March 2018
The demand for certainty is one which is natural to man, but is nevertheless an intellectual vice. … To endure uncertainty is difficult, but so are most of the other virtues.”
– Bertrand Russell
What is a safe haven asset? First, it is a refuge where investors can preserve capital in times of crisis. Second, it is a factor in asset allocation and investment models, influencing diversification assumptions and leverage. Third, it is exchanged as collateral for settlement of any transactions, ensuring solvency in the financial system.
For decades, US Treasuries have acted as the world’s interest rate benchmark as well as the primary haven during market stress, giving the United States an economic advantage over other economic powers.
But what if safe haven countries are no longer stable, and safe haven assets no longer safe?
On the one hand, for years surplus countries around the world have been seeking a way to diversify their reserves and investments away from Dollar assets. On the other hand, US fiscal policy is becoming increasingly unpredictable, while monetary policy threatens a break from its market-friendly past reaction function, adding to rising twin deficits and geopolitical confrontation.
Fixed income investors and central banks have already been shifting capital away from US Treasuries, resulting in a weaker Dollar and stronger Euro and Yen, as well as EM local currency debt. With other central banks following the Fed on policy normalisation, this trend could accelerate.
Is this the beginning of the end for Dollar safe haven assets? And what will be the alternatives for investors? We see a number of implications from a shift from US-centred to a multi-polar range of safe assets.
The first is more selling pressure on the Dollar, with a rebalancing in favour of the Euro, the Yen and major EM currencies.
The second is buying pressure on non-US sovereign debt, including Europe’s periphery, consistent with recent stable price action despite short-term political uncertainty.
Ultimately, investor demand for non-US safe haven assets represents a unique opportunity for China to deepen its domestic capital markets and for Europe to strengthen its capital markets union with a pan-European safe haven asset.
Meanwhile, investors will have to live in a world where US Treasuries are increasingly less safe, but where a substitute asset isn’t yet available. The conclusion is likely to be a different approach to portfolio construction.
US Treasury Bonds: No Longer Safe Haven?
Why are safe haven assets important? Given their stability during crises and negative correlations with the rest of markets, they are suitable as reserve assets for financial institutions, collateral against derivative transactions and generally an instrument to mitigate portfolio risk, especially for multi-asset strategies and risk parity strategies: the more stable and negatively correlated a safe haven asset is against risk, the higher the leverage a strategy can take.
Over the past decades, US Treasury bonds have been seen as among the default safe haven assets thanks to their negative correlations with risky assets. As shown left, 10-year US Treasury bond returns have been negatively correlated with SPX returns since the late 90s, in line with the multi-year global disinflationary trend and bond market bull-run.
Goldilocks is over with the return of inflation and rates volatility. As we argued previously, the risk of an inflation acceleration is rising in the US as the economy continues to expand. The labour market is tight with unemployment rate below the Fed’s projection of long run equilibrium and unfilled job vacancies near all-time high. Yet instead of putting foot on the brake, the US government is adding further fiscal stimulus to an economy that is already growing above potential. While markets have already started to re-price for rising inflation, long-end inflation expectations and rates volatility are still low compared to historical levels, suggesting further room for bond underperformance. Rising yields and rates volatility also diminish the hedging benefit provided by Treasury bonds: as shown left, the correlation between 10-year Treasuries and SPX tends to revert to positive when yield increases.However, this is gradually changing, in our view, as US Treasuries are becoming increasingly risky.
Central bank policy changes could push up risk premia on safe haven assets by shifting their supply and demand dynamics. While considered as safe haven assets, Treasury bonds are never really “risk free” but with risk premia compressed by disinflationary expectations previously and central bank QE since the crisis. Just like any other markets, there is a clearing price for safe haven assets given demand and supply. Central bank purchases pushed up the prices of safe haven assets by reducing the amount of such assets available for the private sector, who need them as bank reserve assets or collateral. In other words, risk premia on Treasury bonds were pushed lower. Now the policy direction is reversing, with the Fed on its course of hiking rates and shrinking its balance sheets. This should mean more supply of safe haven assets for the private sector, and hence lower prices. While the Fed has been the first one to unwind QE and guided for a gradual approach, the real test will come when the ECB and the BoJ also start to normalise their policies. A re-pricing of the risk premia on safe haven assets could mean further reduced diversification benefit from holding these assets.
Twin structural deficits and growing trade conflict: The Trump administration dynamited Republican fiscal orthodoxy with an intended 4% fiscal deficit for 2018 and increasing through his administration. A stimulus of this size might be needed to stoke demand in a recession or during war time, but can’t be justified in the current expansion. The new U.S. Director of the National Economic Council, Larry Kudlow, went further, suggesting an additional round of tax cuts could be discussed. Although largely dismissed as pre-election posturing with US midterm elections due in November, it resonates with our views on populist instincts leaning towards lack of fiscal discipline. The medium term implication remains a clear need for future U.S. administrations to bring the deficit under control, which will limit fiscal flexibility in an economic downturn.
The proposed tariffs’ impact so far is small, but further escalation is likely to devolve into a trade war, hurting confidence and growth. Following Trump’s steel and aluminum tariff announcement in March, the European Union indicated a retaliation plan, as was warned beforehand. If eventually implemented, we would have expected tariffs to trigger some pass-through inflation in consumer goods, offset by reduced demand over time and, to a limited extent, lower corporate margins. Trump may put these tariffs on hold via exemptions on long-time allies, as he turns his focus towards tariffs on intellectual property and technological trade between China and the US. The nominal impact of tariffs on the latter is much higher, and would not be “small potatoes” either to inflation or business confidence, to use Fed member Dudley’s phrasing.
China still a key player in the stock of UST, unlikely to use as a tool to retaliate: China held $1.17 trillion of USTs – 7% of the stock – as of January. They have the option to aggressively sell their holdings and trigger a sharp widening, which cannot be discarded as a tool in the event of an all-out protracted trade war. We do not see a currency-related retaliation as a likely response tool at the moment, as it may undermine CNY’s steady adoption as a reserve currency by global central banks, a key long term Chinese goal. Global central banks hold according to the IMF, an aggregate of $108bn equivalent in CNY, or 1.1% of total reserve currencies. China will likely continue to respond in kind and proportionally to Trump’s trade tariffs, in order to dis-incentivise the US’ behavior, but will be unlikely to take the initiative to escalate further and will seek ultimately to enter talks and perhaps make small concessions to preserve stability, in our view. After all, following the constitutional change in March, President Xi can afford to take the long view.
With such a backdrop however, we do not think long duration UST will remain a reliable safe haven asset the next two to six years, subject to Trump’s potential re-election. While several policy-induced risks may trigger inflationary reactions, these might occur in the middle of a large UST supply increase as well as the Fed’s QE unwinding exercise, which it is unlikely to pause barring a severe economic downturn.
Short-Term Impact: Carry Trades at Risk
Normally in a Fed hiking cycle, the Treasury yield curve would flatten as short-term rates go up and long-term inflation expectations get contained with monetary tightening. However, there is the risk that the curve could steepen this time if the risk premia on Treasuries re-price.
Despite rising risks as discussed above, UST volatility is still too low relative to historical levels, having partially recovered from a volatility pick-up in January. With a potential re-pricing in rates volatility and rising uncertainty over inflation, there is the risk of an aggressive normalisation in term premia and re-steepening of the yield curve. This could be disruptive to risky assets, especially carry trades including in credit, technology stocks, EM FX or various short volatility strategies.
What Could Replace US Safe Haven Assets in the Future?
While US Treasuries are becoming less safe, the demand for safe haven assets as reserves or collaterals continues to grow, especially given post-crisis regulatory changes. An increasing scarcity of high quality safe assets could cause disruptions to the markets’ financial plumbing, as argued by an IMF paper. What could be the alternatives to fill the shortage?
EMs: the Safe Haven Assets of Tomorrow?
EM economies have become economically and politically more stable, but EM assets do not yet qualify as safe haven. Firstly, EM asset fundamentals are still volatile, with EM growth and inflation volatility higher than those in DMs, over the last decade. Secondly, EMs remain reliant on foreign inflows as a source of funding, making the asset class correlated to DM risk sentiment.
However, we think EMs may harbor the new safe haven asset of tomorrow.
As savings and investments originating from EMs exceed those from DMs, the implicit home-bias in selecting a safe haven asset might shift to EMs from DMs. In part, there may be an inherent bias by which the location of the world’s largest investor base dictates the world’s safe haven assets. Until 2000, developed markets were the dominant global saver, but today China and other EMs are. Total EM savings have risen from under 20% of global savings to over 50%, of which Chinese savings are now over a fifth of global savings today, according to IMF data.
More long term EM savings in EM fixed income could help reduce the volatility and correlation of these assets to global risky assets. Since 2011, Asian USD corporate credit volatility has dropped from a high of 6.5% annually to almost 2.5% last year. A dominant force behind this trend has been the shift in the ownership base: Asian investors used to own as little as 40% of the credit market in 2011, but this has since increased to over 70% in 2017. Even amongst Asian investors, asset managers and banks used to comprise almost 90% of local buyers in 2007, but this has dropped 10pp, due to a growth in demand from private banking, insurance companies and pension funds (MS).
China’s domestic bond market could help both EM and DM investors diversify their safe haven holdings. At over $8tr, China’s domestic bond market is the third largest in the world, but non-Chinese investors owned under 2% of the total market, as of Q1 17. However recent regulatory changes has now made available this large asset base for EM and DM investors to diversify their portfolios into. With the potential inclusion of domestic bonds in global indices, this asset class may receive more than $1tr of inflows as investors reallocate capital over the next decade (GS).
European Safe Bonds: A Distant Hope for Safety
At the height of the European debt crisis in 2011 the European Parliament circulated a draft for structured sovereign bonds (the Blue Bond concept), that would attempt to preserve incentive systems for fiscal discipline and pool portions of European sovereign risk together. That plan was not pursued further, and the need for a European Safe Asset to underpin the monetary union remains.
The study presented by the ESRB’s ‘High-Level Task Force on Safe Assets’ in January, focused on senior sovereign bond-backed securities (SBBS), and stressed to limit the chance these assets might cause risk mutualisation between countries. As envisioned, these securities would be structured instruments of existing sovereign bonds with underlying covered pools that necessitate market price references. They would not replace national domestic sovereign bond markets, or help guarantee market access, but their creation would mean the existence of an asset class priced of the Eurozone’s safest assets.
We see the benefits of these assets as helping reduce the linkage between sovereign debt crises and banking crises, if banking regulation is enacted to promote their holdings by EU banks, instead of national bonds, as endorsed by the proposal. It would also deepen the capital markets union by creating a benchmark instrument of the EU’s safest sovereigns. Their proposed structure however, would not serve as a backstop to large weaker issuers in a sovereign debt crisis, something the EU still needs, and we continue to expect opposition to these proposals by fiscally conservative EU states.
Conclusions: From a US-Centric to Multi-Polar Safe Havens
The transition from a US-centric safe haven to a multi-polar safe-haven world, where other economic regions develop their own safe harbours will be a positive one for financial stability. However, investors may have to navigate a limbo interim period where a new safe assets still doesn’t exist, while government bonds from the US as well as other countries, like the UK, may no longer be safe, due to increasing deficits and rising political instability. These are some of the implications:
1.Structural flows out of Dollar assets into other currencies will continue. The Euro, Yen and other EM currencies will be the main beneficiaries. The process will be gradual and long, but ultimately could result into a multi-polar basket of global reserve currencies.
2.Yields on Euro periphery bonds remain among the most attractive globally, when hedged in Dollars. The flow of reserve reallocation will likely trump any political noise, assuming a gradual normalisation from the ECB. EM local debt in countries offering the highest real rates (e.g. Brazil, Russia).
3.Policy normalisation will be harder for the ECB and BOJ, as their currencies will tend to appreciate faster on any signs of interest rate rises.
4.China and Europe will have an opportunity to broaden domestic capital markets. A European safe-haven asset could become a popular alternative to US Treasuries, as deficits and issuance continue to rise in the US.
There are many implications for portfolio construction. The main is that it will be harder to create traditionally robust portfolios, juxtaposing safe haven assets to risky ones. Instead, strategies which aim at being robust in times of crisis – or even anti-crisis – will have to focus on shorting fragile assets rather than finding refuge in safe harbour ones.
The Silver Bullet is Algebris Investments’ macro letter.
Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager for the Algebris Macro Credit Fund (UCITS), joined by macro analysts Tao Pan, Aditya Aney, Abbas Ameli and Pablo Morenes.
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