A mini Minsky moment
When the tide goes out, you discover the bodies of exotic financial fauna stranded on the beach. It happened in 2008, when most of us gaped at sub-prime mortgages, collateralized debt obligations (CDOs) and other such marvels of financial engineering. It’s happening this time too.
It turns out the market fall has led to blood-letting among investors who were betting on what are known as short-volatility financial products. These inverse volatility exchange-traded products had stellar returns in the past couple of years. That led to funds pouring into this trade, so much so that volatility is now an asset class by itself. When the markets fell and volatility spiked, short-vol players lost their shirts.
Why on earth would investors be willing to punt on something that clearly says in its prospectus that a change in market direction could send its value plummeting to zero? The simple answer is: too much liquidity.
Hyman Minsky, the genius whose writings the markets discovered after the financial crisis, warned about this long ago. He wrote, “...over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.” Is it a coincidence that the World Bank head recently called cryptocurrencies Ponzi schemes?
What Minsky may not have anticipated is that central banks themselves would become complicit in encouraging financial excess. They have done so by sending signals that reassure the financial markets the central banks are in their corner, cheering them on and supporting them when they stumble. Consider, for example, the Chicago Fed’s National Financial Conditions Index. This is an index of how loose or tight financial conditions are in the US. As of 2 February, its last data point, this index was at its lowest since 1993, indicating that financial conditions in the US were at their most benign since then. The rate hikes in the US certainly do not seem to have done their job.
The Bank for International Settlements, the central bankers’ bank, has for long been warning of the dangers of keeping interest rates too low. Credit gets misallocated, leverage rises and exotic financial products bloom. Zombie firms, kept alive solely because borrowing is so cheap, proliferate. Investors ignore risk in their search for decent returns.
But central bankers in the advanced economies have pointed to the absence of inflation and of wage pressures in the economy as a reason for not tightening monetary policy. That is perhaps why the markets reacted so skittishly at the first sign of a tiny uptick in US wages. The fear of a return of inflation and consequent Fed tightening led to bond yields moving up and to the stock market fall.
There’s nothing new about this scenario—in the noughties, before the financial crisis, central bankers congratulated each other on the wonderful job they were doing in keeping inflation at bay. They called it the Great Moderation and offered it as an excuse for keeping the markets awash with liquidity. We all know how that story ended.
It is true, though, that inflation has so far been remarkably contained, despite the rise in global growth. The slowing of the frenetic pace of growth in China as well as the structural changes in the crude oil market have no doubt contributed to it. It is quite possible, therefore, that the inflation scare may come to nothing. The markets could take heart from that and in fact, BIS too has said that they do not see any inflationary pressures in the offing.
What then is likely to lead to the next collapse in asset prices? The BIS had this to say: “...the potential role of financial cycle risks comes to the fore. The main cause of the next recession will perhaps resemble more closely that of the latest one - a financial cycle bust.” In other words, it is in the financial system that the seeds of the next collapse will be found. The short-vol meltdown or the bitcoin plunge may not affect the entire market, but they are the tip of the iceberg, a pointer to what lies beneath. This may not be the Big Bust, but several analysts have warned investors to keep a watchful eye on high yield spreads. Recall that the harbinger of the financial crisis was the collapse of two Bear Stearns hedge funds in July 2007 and the Dow Jones Industrials peaked months later, in September.
Why don’t central banks in the developed economies heed the warnings? Simply put, they are afraid. They’re scared that a faltering market may extract a toll on the real economy. The financialization of the western economies has reached such a level that it is the markets tail that now wags the real economy dog. Economic growth is dependent on blowing serial bubbles. Small wonder the Fed did not shrink its balance sheet last week.
Central banks in the developed world are riding a tiger and they have no idea how to dismount.
Manas Chakravarty looks at trends and issues in the financial markets.
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