The Search for Yield
by Ishan Bakshi on 04 Jul 2009 1 Comment

With the rate of contraction slowing down in the western world and emerging markets faring better than expected, confidence about the overall state of the global economy has risen significantly. This growing confidence has resulted in markets, especially emerging markets rallying rather quickly; which in turn has further boosted economic sentiment. In other words a positive feedback loop has occurred. Fund raising which had come to a screeching halt over the last year has started showing signs of recovery. The last few weeks has seen a plethora of companies around the world successfully tapping primary markets.

As global financial markets return to normalcy, the US dollar which had strengthened during the crisis is now on shaky ground. Concerns are being voiced by BRIC economies (collectively they hold $ 2.8 trillion worth of US treasuries) about its long term value. With the crisis and the ensuing policy response creating doubts about the stability of the dollar, the BRIC economies are looking for avenues to diversify. China, Russia and Brazil have already announced plans to buy IMF bonds and have entered into negotiations for using domestic currencies for trade purposes.

However, with estimates that the US will need to raise $2 trillion over the next few years, the situation gets more complex. Treasury holders are now faced with a conundrum. Any sudden move away from the Dollar will destroy confidence in the US and negatively impact the value of their reserves. On the other hand, failure of US treasury auctions will force the FED’s hand which will in effect mean monetizing the deficit. 

Déjà vu

With policy measures having halted the US from plunging into depression, concerns are now being raised about their impact on inflation, the future direction of interest rates and the FED’s exit strategy. 36 South, a New Zealand based hedge fund, whose Black swan fund gained 234% in 2008, has launched an inflation fund on the belief that government injections are bound to lead to hyperinflation.

In a book titled ‘A monetary history of the US,’ Milton Friedman and Anna Schwartz argued that contractionary monetary and fiscal policy were the principal reasons for the great depression prolonging. Then, as is the case now, people feared that excess liquidity would make it difficult to tighten inflation or curb speculation.

The measures people are clamouring for now, such as hiking interest rates, paying interest on deposits with the FED, all dubbed as an exit strategy, had in fact prolonged the crisis back then. High interest rates will have a significant impact on the Adjustable Rate Mortgages. Over the next four years 1 million option ARMs are to be reset higher with the bulk in 2010 and 2011. With unemployment at a 25-year high, higher monthly installments will make loans economically unfeasible (home values have done down drastically and in some cases are well below their purchase price, resulting in negative equity) leading to higher foreclosures, depressing prices and recovery further.

With unemployment at a 25-year high, firms filing for bankruptcy and rating agencies continuing to downgrade companies, the FED should resist the temptation of tightening its monetary policy to avoid a repeat of the 1937-38 crisis. It is thus advisable to end all speculation about the direction of interest rates.

This in turn will have a depressing impact on long term rates, whose recent rise has increased borrowing costs thereby negatively impacting recovery. The FED must raise its inflation tolerance level till the recovery process starts gaining momentum. In other words, a trade off in favour of growth over inflation is needed.

Capital flows

If it is safe to assume that the current low interest rate regime in the western world will prevail for the next few years; then ‘the search for yield’, which was the result of the zero interest rate policy regime of the Bank of Japan, again gaining momentum is quite high. As in the Yen carry trade, funds would be directed to countries with strong currencies offering higher yields.

With US consumers rebuilding their balance sheets, reliance on exports (by emerging economies) for stimulating domestic growth is now diminishing. With focus shifting on enhancing the burgeoning domestic demand, increasing trade amongst developing nations and seeking a substitute for the dollar to decrease their dependence on it, managing currency against the dollar is no longer required. As emerging economies continue on their growth trajectory, their currencies will tend to strengthen vs the dollar (barring central bank intervention). Emerging markets, especially BRIC economies, will undoubtedly be the major avenues for global yield searching funds.

The major obstacle for investment in these countries is the presence of a highly undeveloped and illiquid debt market in most of these countries. Not surprisingly, BRIC dollar bonds have outperformed local currency domestic debt. This is primarily because bond markets in China, India and Russia are highly illiquid. Also their central banks’ interventions in the forex markets to ‘manage’ their currency (to improve export competitiveness) makes these markets even less attractive. These factors limit foreign investment in local currency bond markets even though the credit risk in local currency denominated bonds is lower. It is thus imperative for these countries to develop a highly liquid and deep bond market.

The author is a financial consultant

User Comments Post a Comment

Back to Top