I was going to write about how the markets have concluded that risk does not exist.
After all, early last week, the market thought that dollar bonds issued by emerging economies were not that much more risky than dollar bonds issued by the US, even though emerging economies (unlike the US) cannot print dollars. Admittedly, many do have lots of dollars in the bank. That is one reason why the spread on the EMBI (the leading index of emerging market sovereign bonds) was at record low levels. Mark Gilbert defined spread as:
The number of additional basis points of yield you used to be able to squirrel away by shunning government debt and instead piling into corporate bonds or emerging market bonds. Now archaic.
Risk appetite was quite high.
Even the Bush Administration's Undersecretary of the Treasury for Domestic Finance, Randy Quarles, was worried. He noted on March 1 that the Treasury market was perhaps a bit too quiet:
Moreover, it is clear that financial markets have a great deal of confidence about the future. Last week ... Merrill Lynch's MOVE Index of Treasury bond implied volatilities hit all time lows. A long period of low realized credit losses, lower volatility in GDP growth, and low and stable inflation have led to expectations of more of the same, and thus contributed to a general reduction in risk premia across a wide range of asset classes.
But, like you, we at the Treasury are among those paid to consider the alternatives, and some risks can be found even in what are prima facie signs of strength. Low volatility can create incentives for riskier trading strategies, to maintain return. And currently there is little cost to highly leveraged trading strategies. Swap spreads are at pre-LTCM levels. Financial institutions are facing a flat or inverted yield curve and credit spreads across a number of asset classes are historically tight. This, too, forces market participants to dig deeper to find returns.
[Full disclosure: I worked for Quarles in 2001, when he was on the international side of the Treasury]
Things seem a bit different this week.
Treasuries moved from 4.5 to 4.75 - presumably because of a sense that it was going to become a bit harder to make money borrowing in yen to buy dollars. As Mark Whitehouse and Serena Ng reported on Tuesday in the Wall Street Journal, "bond market professionals attributed the move, which came amid a dearth of economic data, to expectations that strengthening economies will central banks in Europe and Japan to raise short-term rates."
If you import as much capital as the US does, changes elsewhere in the world can have a big impact on markets.
Rising rates in the US, in turn, are reverberating around the world.
The high-flying Turkish stock market wobbled this week. The Turkish lira too. Good thing that - the lira is quite strong, Turkey's current account deficit is hardly small and the latest industrial production data suggest that lira strength is cutting into Turkey's manufacturing sector in a big way.
The consensus seems to be that all these moves are just modest corrections.
Treasury rates moved up, but US interest rates won't move up much more. After all, any move that really started to bite would slow the economy. And a slowing economy would generate expectations that the Fed will change course. Mark Whitehouse and Serena Ng:
"Some economists believe that they are limits to just how high U.S. rats will go .... Higher long-term rates could create pressure on consumers to retrench ... [And] if slackening consumer spending cools the economy, long-term rates should fall, because investors would expect less inflation and would expect the Fed to keep short-term interest rates lower in an attempt to keep the economy going."
All this, I would point out, assumes that foreign investors won't go on strike. Should foreign investors ever lose their appetite for US bonds, US long-term rates might rise even as the Fed started to cut short-term rates. Foreign investors now own the majority of all marketable treasuries, and they should care far more about the dollar than inflation.
And emerging markets are just taking a pause after a big run. No one wants to buy Turkish lira or Brazilian real just before it falls, but maybe some folks will want to buy in after a (still relatively small) fall. The carry, after all, is still attractive.
So at least argues Hans Redeker in the FT:
Hans Redeker, head of currency strategy at BNP Paribas, saw scope for a two-month reversal in the emerging market bull run as investors reassessed risk, but argued that a correction would be a "disturbance prior to the return of another wave of risk appetite once prices become appealing again."
Or just maybe, something really is changing. Maybe the rest of 2006 won't be like 2005. Maybe bets on stable treasury prices, shrinking credit spreads and high-yielding currencies may not work quite as well as they did.
As Dan Drezner would say, developing ....