The Ultimate Wall of Worry - Part 2
03/31/06
The Financial Times wrote this past Monday: "The New Zealand and Icelandic currencies slumped to new 22-month lows last week amid fears of recession as their economies feel the weight of high nominal interest rates and the previous strength of their currencies. Both are also laboring under massive current account deficits - 8.9 per cent of gross domestic product in the case of New Zealand and 15.5 per cent in Iceland. These deficits may become harder to finance as foreign investors avoid their currencies. ..."
Iceland and New Zealand have been big beneficiaries of the global carry trade in which a plethora of investors from US hedge funds to Japanese retail investors borrowed in cheap dollars, euros and yen to chase better returns in higher interest-rate countries. The global carry trade - the practice of borrowing in low-yielding developed market countries and snapping up more lucrative assets, generally in emerging markets - has been a no-brainer in recent years. Emerging market bonds, as measured by JP Morgan's EMBI+ composite index, have returned 102% since July 2002. The MSCI Emerging Markets stock index has surged 192% since March 2003 and emerging market currencies have outperformed G10 currencies by 11% cent over the past year. It seems, however, that the events of the past months have raised doubts among investors and that some of them are becoming less confident. The hot money is already leaving for safer shores.
Just this past Wednesday, Iceland's central bank was forced to raise its overnight lending rate by a higher than expected 0.75% to 11.50% in an attempt to head off a crisis of confidence in the krona, that created ripples in markets far beyond the tiny North Atlantic country of 300,000 inhabitants. The Icelandic krona has fallen 12 per cent against the US dollar so far this year, and the New Zealand dollar has tumbled 10.7 per cent as both currencies have hit nearly two-year lows. Ever since the 1997 Asian contagion Crisis has it become obvious that trouble in one emerging market can spiral out of control and cause repercussions in seemingly unrelated markets halfway across the world. It seems that the decade of the carry trade is coming to an end. Carry trade investors have to be concerned that as interest rates rise in the US, the Euro-Zone and Sweden, the cost of funding a trade also rises. Funding costs have even started to rise in Japan, despite the fact that few analysts expect Tokyo's zero interest rate policy to be scrapped any time soon. The yen has already made gains in expectation of a change in policy, putting further pressure on yen-funded carry trades.
The carry trade phenomenon may be moving from an indiscriminate stage, when almost any trade involving a yield pick-up would do, to a more discriminating phase. If Japan, Europe and the US all raise rates simultaneously, it will have a psychological effect reminding managers that fundamentals matter at times.
"Carry is no longer king," said Jens Nordvig, currency strategist at Goldman Sachs. "Investors were almost blindly seeking returns in emerging markets, now they will have to scrutinize the fundamentals." Neil Mellor, currency strategist at Bank of New York says "It is our contention that the foreign exchange market's pre-occupation with interest rate differentials will be usurped by a revival in deficit concerns." However, many observers remain relaxed about the future of the carry trade. They note that although monetary policy is becoming tighter in major funding markets, broad money supply is still expanding at a rapid rate providing plenty of liquidity. "Interest rates may tell you the price of money, but money supply dictates the quantity of money, and monetary aggregates are growing very fast," says Marc Chandler, at Brown Brothers Harriman. "The price of money still remains pretty low and I'm hesitant to say this is the end of the emerging market rally," says Mr. Chandler, who takes comfort in the improving fiscal and external balances of many emerging market nations. It seems that the stage is set:
On one hand, the central banks around the world are raising interest rates (because they want to combat rising inflationary pressures or because they have to attract money to finance deficits) and thus drain worldwide liquidity. On the other hand, institutional investors like banks, funds and other pools of money are chasing yields by leveraging up or investing in risky assets, thus adding to worldwide liquidty.
So while the price of money (interest rates) is slowly rising, the amount of money is still expanding rapidly, aggravated by the fact that since 2003 the velocity of money, that is the ratio of GDP to the money supply, or how many times a dollar turns through the economy during the course of year, is also rising.
Rising monetary aggregates and rising velocity are a recipe for rising inflation - and this is the primary fear of all central bankers. The dramatic rise in the precious metals lends validity to the concept that inflation is rising. The consequences for investors are not uniformly bad, but the air is getting thin in certain areas of the world. What is happening right now is probably the beginning of the end. The structurally weak currencies are suffering first. They lose sponsorship among investors. Dramatic losses in the markets of those structurally weak economies
re-introduce the concept of risk into the psyche of investors. Structurally strong currencies and economies are benefiting at first from the newfound risk aversion. This is the phase we are in right now in the U.S. markets. While the first quarter saw record amounts of individual investors' money being invested in emerging markets, the smart money is already returning from abroad, giving U.S. markets another push. This can go on for a while but eventually, the rising cost of money and diminishing returns in extremely leveraged accounts will bring the game of musical chairs to a full stop. What comes after that is usually not pretty. As I said four weeks ago: As long as the Fed raises interest rates, markets are going to rally. The time to worry is once they stop for "some reason".
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
