from Follow the Money

So much for a no volatility world

January 21, 2008

Blog Post
Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Hard as it is to believe on a day like today, those who expressed concerns about the sustainability of the global expansion around this time last year were mocked as worry warts.

A FT headline from Davos 2007 read "Big risks to the global economy receding." Back then, more and more voices argued that global imbalances were a natural byproduct of dynamic globalization. Few warned that if the US couldn’t attract enough (net) private capital inflows to cover its deficit in good times, it would almost certainly fail to attract enough private capital inflows in bad times - and might need, for example, to sell off a large swath of corporate America to sovereign funds to "fund" its deficit.

The dominant debate - if memory serves - around the turn of last year centered on whether the equity markets had fully priced in the fall in macroeconomic volatility. Credit spreads were incredibly low at the time - but that too was thought to be more a reflection of limited macroeconomic volatility  than a reflection of an (overly) exuberant credit market.

The US had, after all, managed to withstand the collapse of the .com bubble with only a mild recession. The seemingly inexorable rise in the price of oil had failed to put a dent in the US consumer or the US economy. Hedge funds had failed -- Amaranth -- without causing much stress in the market. The risks associated with the trade deficit never seemed to materialize. All was clear.

In an environment marked by little macroeconomic volatility, limited financial volatility, and low credit spreads, equities looked undervalued. There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.

The same basic view marked the foreign exchange market. Low macroeconomic and financial volatility made carry trades attractive. The more leveraged, the better. There was little need to worry about the large resulting deficits in (some) high-carry countries that were the recipient of such inflows.

More somber voices had started to warn of building risks - whether from rising oil prices, speculative excesses in the housing market, low levels of household savings in the US, high levels of investment in the US or a global flow of capital that seemed the reverse of what conventional economic wisdom would expect - back in 2003 or 2004. They had been wrong for an extended period.

Being wrong meant leaving money on the table. Financial history is written by the winners. They are the ones, generally speaking, who can afford Davos.

The world looks incredibly different today. Just look at the posts over at Calculated Risk.

The equity market seems to have lost confidence that macroeconomic volatility has disappeared - and that existing corporate earnings should consequently be priced at a higher multiple. The private equity put disappeared in a world of hung bridge loans. The SWF put doesn’t seem quite as powerful as some hoped.

The bull market in credit is over.

""The reality is we’ve gone from a raging bull market in credit to a bear market. Now people are worrying about anything and everything," said David Brickman, director of credit strategy at Lehman Brothers."

And it turns out that credit risk wasn’t quite as dispersed as some thought. Sure, the Bank of China (BoC) had taken on some subprime exposure. But not near as much as Citi, Merill and Morgan Stanley. The really big pools of sovereign money - think China’s State Administration of Foreign Exchange and the Japanese Ministry of Finance - seems to have largely avoided the biggest subprime related excesses. The BoC’s $60-70b of bonds (If Goldman’s research on the Bank of China is right and the BoC’s total bond portfolio was $90b at the end of 2006, the Areddy/ Leow Journal article may slightly understate the BoC’s total bond exposure) pale relative to the PBoC’s $1400b or so of bonds.

It no longer seems clear that the global economy can decouple from a US recession. The world economy did, in my view, decouple from the US to a remarkable degree from a slowing US in 2006 and 2007. Non-oil US import growth has been slow for some time. But Europe picked up a lot of the slack, emerging as the number one destination for Chinese and Japanese exports. Now though it isn’t clear that Europe can continue to be a locomotive for global demand - and the world needs a non-American locomotive more than ever.

The only risk that doesn’t seem to have really materialized is risk that I have obsessed over for the past several years. The dollar’s decline so far has been fairly orderly. Setting the moves in the yen (especially v the kiwi) on a couple of days in August aside, the currency markets really haven’t moved like the equity markets did today. Low Treasury bond yields suggest that foreigners have retained an appetite for Treasury bonds.

Thank the world’s central banks.

Global reserve growth has never been faster, or put differently, the advanced economies have never been as dependent on financing from emerging market governments as they are now. My guess is that the extent of dollar asset accumulation in the world’s central banks (counting China’s now chastened state banks, who still manage funds for the central government) would truly shock if the sum were every to be transparently revealed. Many big central banks don’t report data to the IMF, and others have gotten more and more skilled at hiding their intervention.

But such reserve growth - and the associated pressures created by a rapidly growing net long position in dollars among the world’s governments - also has consequences. Think of Summers’ warnings about the balance of financial terror. The world’s central banks aren’t adding to their net long position in dollars because they want more dollars. Rather, they fear the consequences of stopping.

Maybe someone will reach the a simliar judgment about the monolines.

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