The strange meltdown in financial markets
Monday 28 February 1994
Admittedly, the decision of the Federal Reserve to increase interest rates by a quarter-point on 4 February could be seen as the trigger. But the reaction has been rather extreme. Since the Fed's announcement, the yields on 10-year bonds around the world have generally risen by 0.5- 0.75 per cent - the bond equivalent to a large earthquake.
The standard explanation for this is that 'speculative' investors, including the so-called 'hedge funds', had become heavily over- invested in bonds (especially European bonds) by the early part of this year, and that the sell-off has been caused by a stampede among these investors to close their positions. On this view, the behaviour of mobile short-term investors (let us call them the 'hedge funds' for short) have exacerbated both the upward and downward movements in markets in the past year, greatly adding to the volatility of asset prices.
Certainly, the hedge funds and their kindred spirits have access to much greater capital resources today than ever before. Several of the older funds have generated annual rates of return of between 50 and 70 per cent for several years, which alone has hugely increased their financial muscle. Furthermore, new funds have been swamped by money from investors fleeing from 3 per cent returns on American cash.
But the main reason for the power of the hedge funds is that (unlike many investors) they are able to use 'leverage' to maximum effect. For example, a hedge fund with dollars 1bn of investors' capital might borrow enough money to hold bonds worth dollars 10bn. If bond prices rise 10 per cent, the hedge fund doubles its money; but if bond prices fall by 10 per cent, the hedge fund is wiped out. Obviously, a global bull market in financial assets can, for a time, produce hugely flattering returns to anyone who adopts this strategy.
Many of the older hedge funds are managed by some of the most astute traders in the world today. Their risks are carefully controlled, and they will probably continue to provide a useful service to some categories of investor in any future market conditions. But it is hard to avoid the suspicion that the sudden explosion in new funds in recent months has been driven by the same mania for 'leverage' that has characterised bull markets since time immemorial. And it would also be normal for some extreme pain to be suffered as investors once agin learn the time-honoured lesson that leverage does not always pay.
Quite often in the past (in October 1987, for example), the deleveraging process has caused a severe crash in asset prices. So far on this occasion, the process has been much more controlled. Nevertheless, central banks are said to be worried that they do not have enough information to monitor the hedge funds, especially in the derivative markets which are not fully regulated. There have been reports that the central banks will try to reduce the 'funding' available to hedge funds, forcing them to hold smaller positions, with much less leverage.
If this is the intention of central banks, they will need to be cautious about introducing such a policy, since it could initially cause a further collapse in asset prices as the hedge funds are forced to liquidate positions to reduce leverage.
No doubt central banks are aware of this risk, but they have been eagerly awaiting an opportunity to curtail leverage for some time, and a move in this direction, perhaps accompanied by temporary cuts in short-term interest rates in some countries, is a possibility.
In the longer term, the behaviour of the financial markets will presumably return to more normal conditions, in which fundamental value will re-assert itself. Fortunately - and this is the key reason the deleveraging process has not been as painful as it was in 1987 - most of the financial markets do not seem to be priced particularly expensively relative to normal. This mitigates the chances of a serious crash, since it means that long-term investors will tend to step in with purchases if the more 'speculative' players become heavy sellers.
The table shows some snapshot valuations of bonds and equities relative to inflation and short-term interest rates. First, let us consider the bond markets. In order to be persuaded to hold a 10-year bond, as opposed to a shorter dated instrument, the investor must believe that being locked into long term debt will produce a better return than leaving cash in the money markets - a strategy that would maximise flexibility.
Under normal circumstances, long bonds must therefore offer a higher yield than the expectation of cash returns (ie successive short- term interest rates) over the life of the bond. Consequently, one way of valuing bonds is simply to take their yield relative to current short rates. And, since the market's expectations of short rates are undoubtedly related to inflation expectations, it is also important to value bonds against expected inflation. This involves an inspection of real bond yields.
Real bond yields in the important markets vary from 2.8 per cent in Japan to 4.9 per cent in France. Compared with previous cycles, these yields look about right in the US, quite high in the UK and France, and somewhat low in Japan and Germany. In other words, it is a mixed bag, but with little sign of a chronically overvalued bond market on a global basis.
Relative to current short rates, the US and Japanese markets seem to offer outstanding value, the UK gilt market is about right, and the continental European markets look extremely expensive. This offers a fundamental clue to what has been happening recently in the European markets.
As the European recession deepened, the markets became convinced that there would be huge cuts in short-term interest rates, led by the Bundesbank, but so far these have not been fully forthcoming.
From now on, we must either get further cuts in European short rates, or bond yields on the Continent will continue to rise, thus slowing the recovery from recession. Faced with this unintended tightening in policy caused by the bond markets, the Bundesbank will surely reduce short rates again soon. (Either way, though, the European yield curves must certainly steepen, so that bond investors receive enhanced returns relative to cash.)
Finally, equities. At present, all the large stock markets (except Germany) look cheap relative to short rates, and none is chronically overvalued against bonds. This situation stands in sharp contrast to October 1987, when equities were massively overvalued relative to both bonds and cash. With the world economy now recovering, a global equity crash is not the most probable outcome. But if it does happen, get ready to empty the building society to buy stock.
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