from Follow the Money

It is hard to bet on curve flattening when the curve is already flat

January 30, 2006

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Or spread compression when spreads have already compressed.

As David Altig kindly noted, I was quoted in Clint Riley's Wall Street Journal story about the impact of a flat yield curve on bank earnings:

There is a very flat yield curve globally for different reasons, even in some emerging markets," said Brad Setser, head of global research for the Roubini Global Economics Monitor, a New York-based economics Web site. "I really don't see where the easy money is. No matter how sophisticated you are, you can't get away from the basics of banking: Borrow short, lend long."

Why no easy money?   Here is what I see:

A flat yield curve in many advanced economies.  There is no money to be made borrowing short and lending to the US government, for example.   The globally flat yield curve probably has a thing or two to do with oil - with oil at $65, the big oil exporters could earn something like $830 billion on their oil exports this year (assuming OPEC and Russia produce about 45 mbd of crude and similar product, and consume maybe 10 mbd, leaving 35 mbd in net exports).  And a lot of that money is being saved, not spent. 

Thin credit spreads.  Last year, William Pesek spoke of Kate Moss thin credit spreads.  That hasn't changed much.    Low spreads mean that the banks cannot make much money by taking on additional credit risk - and are exposed to losses should credit spreads widen (if they mark to market).

A flat yield curve in many emerging economies.   There is no money to be made taking in short-term deposits in say Brazilian real and then buying longer-term real denominated bonds.    Yes, you can make money if long-term real rates fall.  But it not so easy to make that bet when the Brazilian yield curve has inverted, and you lose money waiting for long-term spreads to fall.  Brazil's over night rate is 17.25%, one-year Brazilian bonds yield 16.1%.

Where is there money to be made?   Well, by taking on a bit of currency risk.

Borrow short-term in dollars, euros or yen, and buy high yielding Brazilian real, among other things.  

But there are limits (one hopes) on the banks' willingness to take on currency risk.  Commercial banks are not central banks.

Still, there is a reason why money poured into Brazil in 2005, and earlier this month.

The scale of these flows to a range of emerging economies is rather remarkable.   As is the scale of the resulting increase in the reserves of many emerging markets.

By my rough calculations Brazil added something like $25 billion to its reserves in 2005.  A bit more actually.  See Gray Newman.  The central bank's intervention does show up in Brazil's headline reserves because Brazil paid back its entire IMF loan last year.  But Brazil's net reserves (reserves - IMF loans outstanding) soared from $27.5 b to roughly $54 b during the course of 2005.   And it looks like Brazil added another $3 b to its reserves this January.

Turkey's net reserves increased by something like $23 b in 2005.  And Turkey, unlike Brazil, is running a current account deficit - which makes its reserve increase all the more impressive.

Argentina added something like $13 billion to its net reserves in 2005.  That's why it was able to repay the IMF.

All told, the net reserves of Brazil, Argentina and Turkey increased by about $60 billion in 2005.   For comparison's sake, that is just about as much as the IMF lent out to these three countries in 2001 and 2002.    And those were very big loans by the IMF's standards. 

No doubt, the fundamentals of these countries have improved.   All have far better fiscal stories now than in 2000 - or 1997.   But it is also hard to avoid the conclusion that these recent flows have been driven in large part by developments in the advanced economies.   Right now, there is no shortage of appetite for emerging market paper.

All three countries needed to build up their net reserves, which were on the low side.  They are not China.  But looking ahead, they will have to balance the benefits of higher reserves against  the costs.  Those costs are higher -- or at least more visible -- if local interest rates are high. Brazil's central bank loses money when it sterilizes its growing reserves even if the real/ dollar stays stable. China's central bank only loses money if the RMB appreciates.

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