As the polling date for the US presidential election approaches, there is a mounting sense of anxiety and anticipation in the financial markets. Investors are thrashing about the water without going anywhere. But, political, economic and financial market fault lines are clearly visible and they may collide at any moment, producing a cataclysmic outcome.
In recent months, the three-month US dollar London Interbank Offered Rate (Libor) has gone up to around 0.9%. This was attributed to funds fleeing prime money market funds into government money market funds due to a regulatory change requiring prime money market funds to mark their net asset value to the market. The change has already been effected. Yet, the Libor rate has not shown any sign of coming down.
If it remains at these levels, it will suggest a dollar liquidity tightness in the market. As to the source of such tightness, one has to turn to the woes of European banks as the likely origin.
It is significant that the Bank of England has sought details from UK banks on their exposure to Deutsche Bank and Bank Monte dei Paschi.
At the same time, in recent weeks, the US 10-year treasury yield has gone up by 50 basis points. It is unclear as to what the real trigger is.
Fundamentally, data flow on US economic activity and price developments remains mixed, as usual. The up-and-down movements in the price of crude in recent years have not had much of an impact on inflation.
The explanation seems to be that financial markets fear that central banks have reached the end of their tether with respect to quantitative easing, forward guidance and negative rates. Hence, attention is slowly shifting to fiscal policy and the possibility of fiscal pump-priming to boost real economic activity. If so, the bond market reaction must be a warning to those who argue that governments have fiscal room to boost economic growth.
Most advanced countries have a high stock of government debt. Their efforts to rescue their banks and their economies after the crisis of 2008 have increased government debt.
According to data compiled by the Bank for International Settlements, general government debt/GDP ratio in advanced economies was 71.3% in December 2007. By the end of March 2016, it had increased to 113%.
The debt stock does not provide room for governments to engage in aggressive fiscal expansion. Should they do so, the risk of a significant rise in government bond yield is high. Perhaps that is what the recent run up in bond yields is signalling.
Commentators who had been clamouring for more inflation have become nervous. Despite central banks manipulating asset prices, the bond market has shown its independent hand.
The recent jump in government bond yield has not resulted in an increase in high-yield bond spread. It continues to grind down.
However, if yields on corporate bonds—investment or high-yield—rise too in tandem and in sympathy with government bond yields, then it will be a calamity in financial markets.
Most of the bonds issued in recent months will face immediate and big losses as their duration is very high. By some measures, the high-yield spread is more than two standard deviations tighter than implied by fair market valuations. It was this low last time in April 2008.
While the American economy allegedly bounced back to a higher growth rate in the third quarter, the monthly “Oil Market Report” of the International Energy Agency (IEA) for September and October 2016 make it very clear that economic growth remains challenging.
According to the September report, the global oil demand was slowing at a faster pace and non-Opec supply would return to growth in 2017. The October report stated bluntly that demand growth continued to slow, dropping from a five-year high in 3Q15 to a four-year low in 3Q16 due to vanishing OECD growth and a marked deceleration in China.
The IEA predicted that the market might remain in over-supply through the first half of next year. Therefore, the recovery in the crude price from around $26 per barrel to around $46-50 per barrel is likely unsustainable. The difficulties that Opec faces in operationalizing its production cut-back agreement confirms this prognosis.
The observation made by the IEA on China is important. China’s economic activity is being sustained by credit from banking and non-banking sources. In a commentary that is available only to clients, Standard & Poor’s noted on 19 October 2016 that the trade-off between credit losses and net interest margins would not necessarily favour the Chinese banks.
As the credit surge exacerbated a bank’s asset quality, capital and liquidity, a major weakness in any of these inter-connected areas could derail a bank. China remains a major source of risk for financial markets. Well, almost all major economies are sources of risk for asset prices.
Mohamed El-Erian, formerly with the Pacific Investment Management Co., and now chief economic adviser with Allianz, has raised cash levels in his portfolio to 30%. He reckons that there is enormous risk in public markets because they are “distorted by central banks to the greatest extent”.
V. Anantha Nageswaran is an independent financial markets consultant based in Singapore.
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