Curiouser and Curiouser
through the looking glass and down the up staircase
The dollar was strong; the dollar is now weak. Stock markets were at all-time highs; now they are in headlong retreat. Emerging markets offered long-term rapid growth; now they are mired in recession. Long bonds were a safe haven; now even they lack a sufficient comfort factor.
Financial markets seem to have entered a looking-glass world in which all the assumptions of recent years have been turned upside-down. "Contrariwise," continued Tweedledee, "if it was so, it might be; and if it were so, it would be; but as it isn't, it ain't. That's logic."
Can things really be so odd or are investors merely suffering from what might be called "irrational exhaustion"? The wild swings that have affected currencies, equities and bonds in recent trading certainly show that something is seriously out of kilter in the financial system.
The traditional devices for assessing market movements have had to be thrown out of the window. No commentator could have predicted the collapse of the dollar against the yen on the basis of the relative strengths of the US and Japanese economies, financial systems or their interest rate structures. "If you claim to understand exactly what is going on at the moment, then you probably don't know what you are talking about," quipped one analyst yesterday.
It is standard financial theory to assume that the markets are priced in line with economic or corporate fundamentals. That certainly is a good rule of thumb for the long term.
But in the short term, a more important factor comes into play: liquidity. A share, bond or currency is worth what someone is willing to pay for it. When the balance of buyers and sellers is upset, that can lead to very sharp movements in prices, like the bargain offers shoppers find at the January sales.
Hedge funds are all too often the "usual suspects" after an unexpected market movement. Analysts seem convinced that some of the last week's most dramatic price shifts - notably the decline in the dollar from Y136 on Monday to Y111 at one point on Thursday - were the result of the more speculative funds reducing their positions.
Being short the yen (gambling that the Japanese currency will fall) and long the dollar, particularly dollar bonds, has been a very profitable play recently. Interest rates worked in your favour since you were borrowing from the Japanese at less than 1 per cent and lending to the US government at more than 5 per cent. The strength of the dollar gave you a currency bonus.
How exactly this strategy came unstuck is not clear. In the wake of the near-collapse of Long-Term Credit Management, a US hedge fund, lenders around the world have reduced credit facilities to all hedge funds, forcing them to cut their positions in all markets. Or it may be that the dollar had already slipped enough from its previous high of Y147 that funds were panicked into cutting their losses. That meant selling bonds - the long part of the trade - as well as buying back the yen.
What is apparent is that another "looking-glass" element of the recent turmoil has been a change in attitude towards risk and those taking risks. For years, share prices were rising (in Europe and the US at least), bond yields were falling and credit was plentiful; one did not have to be a genius to make money in developed financial markets.
But the emerging market crisis that began when Thailand devalued the baht last year has steadily increased investors' risk aversion. One by one, the safe havens have disappeared, rather as hunters stop up fox-holes to prevent their prey's escape.
It was assumed that European equities would be an oasis of calm amid the turmoil of emerging markets; but the DAX index in Frankfurt is more than 35 per cent below its July peak. Enthusiasts claimed high-tech stocks offered the kind of long-term growth that made them immune to the vagaries of the economic cycle; the Nasdaq index, which is weighted in technology stocks, is down nearly 30 per cent.
With the US dollar and long-dated Treasury bonds also losing some of their attractions in recent days, investors are fast running out of cubbyholes. Even the most conservative investment no longer seems reliable. "In the current environment it takes a brave man to take money out of his pocket and put it into the gilt market [for UK government debt]," said Steve Scott, an analyst at Dresdner Kleinwort Benson yesterday.
In the end, when investors get into a funk, there is only one sure place for their money - cash - and the "dash for cash" is often a sign of the final throes of a bear market.
It certainly seems as if the process has speeded up. Traditional bear markets were long drawn-out affairs in which activity slowed to a standstill. Each rise in prices was merely a "suckers' rally" which allowed the smart money to get out, and investors eventually gave up in despair.
The average bear market since the second world war has lasted 14 months.
It may be that the advent of the hedge funds has accelerated the cycle. Investors have been speculating with borrowed money all the way back to the South Sea Bubble. But the scale and scope of the operation has changed. "The emergence of such large speculative investors operating with high levels of leverage on a global basis has no parallel in modern financial history," says David Hale, chief economist at the Zurich group. Leveraged investors have to sell, and sell quickly, when prices move against them.
At the same time, the development over the last 20 years of financial futures exchanges and over-the-counter derivatives has made markets more efficient. Liquidity has improved and that has made it easier for shifts in investor mood to be translated quickly into prices.
"Here you see, it takes all the running you can do to keep in the same place" said the Queen. "If you want to get somewhere else, you must run at least twice as fast as that."
This could be good news for investors. After the stock market crash of October 1987, the worst was just about over by the end of the year. This time round the US Federal Reserve and the Bank of England have already cut interest rates and more reductions may be on the way; the International Monetary Fund and the Group of Seven leading industrial nations appear to be willing to make another attempt to draw a line in the emerging markets crisis and stop it engulfing Brazil.
But before markets can calm down, a few significant worries need to be sorted out:
•The Japanese financial system. The Japanese government has been edging towards a plan for the rescue of its banking system. But most observers doubt official figures on the size of bank bad loans and the recent falls in the Tokyo stock market will not have helped the sector, which counts unrealised share price gains as part of its capital. "We expect a number of banks will report they are insolvent if forced to mark their 'hidden assets' to market values at the September 30 levels of the Nikkei," says Carl Weinberg of High Frequency Economics.
•The hidden horrors. Traders are fond of the "cockroach theory" which states that you never find just one cockroach in a kitchen. Similarly, no-one believes that Long-Term Capital Management will be the only institution to have been savaged by the recent market movements. There were rumours that the Tiger hedge fund was behind a substantial part of the dollar/yen move this week but, even if it successfully liquidated its position, what about other investors who had bet on the dollar? Regulators are likely to be particularly concerned about the trading arms of the big banks.
•The economic fallout from currency movements. A weaker dollar and stronger yen will help some of the Asian countries that are competing against Japan and have dollar-denominated debts; it should take the pressure off the Hong Kong and Chinese authorities to devalue.
But the yen's rise will not help Japan's exporters at a time when that sector is the country's sole bright economic spot. And it is very bad news for the European corporate sector, which has been basking in a strong dollar for three years.
Tackling imbalances in foreign exchange markets is like sitting on a balloon; no sooner have you successfully squashed one part of the problem than it bulges somewhere else. Everyone cannot devalue their currencies at once; some countries are going to see a severe deterioration in their trade positions.
These problems may seem overwhelming but that is the nature of bear markets. For stock markets in particular, a lot of bad news has already been priced in. In time, investors will adjust to this new unfamiliar world and as leveraged funds retreat from the market and interest rate cuts relieve some of the liquidity pressure, volatility will diminish. As Lewis Carroll's Queen said: "Sometimes I've believed as many as six impossible things before breakfast."
The Financial Times, October 10, 1998 |
