Here Come the Troubles of August
Widening swap spreads portend problems
For the third year in succession August is proving to be a month of extreme financial turbulence. The US equity and bond markets have been nervous. The dollar looks distinctly tired after its long bull run. Meanwhile, rumours are rife that at least one investment bank has incurred big losses on its proprietary trading activities.
The trouble is thought to have arisen in the interest rate swaps market, which is going through unprecedented and stressful contortions. Such swaps are the derivative instruments that allow companies and banks to exchange their fixed interest income flows for floating ones, and vice versa.
Last weekend William McDonough, the head of the New York Federal Reserve, felt the need to tell Dow Jones Newswires that he knew of no situation that posed a systemic risk. It was the kind of central banker's denial that offers mixed comfort to nervous investors and traders.
By the middle of this week, conditions in the markets had started to stabilise. Does that mean the scare is already at an end? Probably not, because the behaviour of markets still points to considerable aversion on the part of investors and borrowers to taking on financial risks.
Even after Mr McDonough's statement, spreads on 10-year swaps were higher than at the time of the financial crisis in August 1998. The spread reflects the difference between the fixed rate being swapped and the yield on a benchmark Treasury bond of comparable maturity. Any widening of the spread points to increased concern about the risk of lending money to companies relative to lending it to the US government - regarded as the most creditworthy of borrowers.
This is noteworthy because it was the extreme gyration in swap spreads that helped to inflict such heavy damage on John Meriwether's Long-Term Capital Management, the hedge fund that was rescued by its bank creditors a year ago. To the extent that LTCM and others have stuck to their original strategies in the hope that they would become profitable again in less volatile markets, there is obvious scope for more trouble. That trouble could affect both hedge funds and the proprietary trading desks of investment banks.
Sticking to the original trading strategies would have seemed amply justified as late as June this year. But the market gyrations of the past six weeks could have reversed many of the gains. Indeed, all financial institutions that have based their trading strategies on the assumption that historical relationships in the markets would hold firm are now likely to be facing losses. What is causing the trouble?
The immediate financial pressure reflects concern that the Federal Reserve will shortly raise US interest rates again. Companies are refinancing bank borrowings in the corporate bond market in order to lock in today's low interest rates.
Many are worried that the corporate bond market will become illiquid because of the Y2K millennium computer problem. They have brought forward their borrowing plans. The pressure that arises from such heavy issuance is part of the reason why spreads have widened in relation to the US Treasury market, where the government is now buying back its own debt.
The same pressure is reflected in spreads in the swaps market where corporate treasurers simultaneously hedge interest rate risk in deals related to the bond issue. While corporate demand for bond finance is exceptionally strong, the supply of capital is now affected by a shift in the global economic background, and possibly also in the way the US economy works.
The US economy's ability to grow faster than its underlying potential for long-term growth has depended recently on the continuation of a virtuous circle. The existence of surplus capacity in the much weaker Asian and European economies has imposed benign disinflationary pressure on the US. Surplus liquidity from the weaker economies has also been sucked into the US capital markets, thereby contributing to dollar strength. That has in turn kept import prices in check.
These strong capital inflows have helped finance a stock market and corporate investment boom at a time when US households are spending in excess of their income. So the economy has continued to grow despite a growing current account deficit that reflects the shortfall of domestic savings against investment. Economists such as Tim Congdon of Lombard Street Research and Bill Martin of Phillips & Drew have long argued that these imbalances in the US economy are unsustainable. The difficulty has been to predict precisely when international investors will shy away from financing a current account deficit that is running at $30bn a month.
With the European economies and much of Asia now recovering, the growth of global liquidity is slowing. Moreover, the change in sentiment towards the dollar since mid-July carries a strong hint that global capital flows may be changing direction. Certainly US and European institutional investors have been pouring large sums into the Tokyo market this year. The weakness of the US bond market points to a similar conclusion.
So the widening of credit and swap spreads is a direct reflection of tighter supply and demand conditions in the capital markets. The question is whether a repeat of the financial crisis that followed last year's Russian default is under way. The present credit crunch is clearly less severe. Big companies are still able to raise funds in the bond market - at a price. Nor are spreads in the US Treasury market widening as they did in 1998 to reflect fractional differences in liquidity between bonds.
Yet the markets have a very fragile feel. And if a shift in the pattern of global capital flows is indeed under way, the scope for shocks will increase. One potential horror story concerns the currency markets. As Paul Krugman, the US economist, has pointed out, a weak dollar would lead to economic contraction almost everywhere. This is because currency depreciation prompts a positive demand shock in the US and a negative supply shock for the country concerned.
That is to say, US goods would become more competitive around the world, thereby increasing demand in an economy where demand already outstrips supply. At the same time a devaluation-induced increase in import prices would further constrain supply that already falls short of demand. With the US economy operating with no slack at all, a sudden dollar decline would lead to a wage-price spiral, which would probably force the Fed to raise interest rates.
For the rest of the world, which still suffers from weak demand and is only now beginning to recover from an economic setback, currency appreciation would have an equal and opposite effect. It would no longer be possible to rely on the US as the global spender of last resort. Yet the ability to respond to a falling dollar by reducing interest rates is limited in Europe and more especially Japan, where short-term interest rates are close to zero.
A changing pattern of capital flows also poses a threat to heady valuations in US equities. For as Brian Reading, the economist, argues, there are intriguing parallels with 1987. The crash of October that year, the worst since 1929, is thought to have been partly caused by rising interest rates around the world, and a row between James Baker, the then Treasury secretary, and the Germans after a Bundesbank rate increase. Mr Baker was worried that the Germans were reneging on their obligation under the 1987 Louvre Accord to support the dollar when the current account deficit on the US balance of payments was approaching 4 per cent of gross domestic product.
Mr Reading says the role of the Japanese, though largely ignored at the time, was important. On the eve of the crash, the Japanese Ministry of Finance was arm-twisting domestic financial institutions into buying $40bn-worth of privatisation shares in Nippon Telephone and Telegraph at an astonishing multiple of 300 times earnings. As a result, the flow of portfolio capital to the US from the world's biggest creditor country dried up. The recent intervention to curb the appreciation of the yen carries an interesting echo of the Louvre interventions. There are equally suggestive parallels in today's weakening bond markets and rising interest rates, accompanied by a deteriorating US current account.
Of course, when the US equity market finally collapsed in October 1987, it was none other than Alan Greenspan, the Fed chairman, who came to the rescue. Confronted with a shock that threatened the financial system, he opened the monetary sluice gates, as he did in the crisis last autumn. Can the markets rely on Greenspan coming to the rescue yet again if the collapse of a big institution poses a systemic threat or the markets take a severe tumble?
It would certainly be harder for him to do so. Last year, the threat of deflation was sufficiently real to justify a significant loosening of policy. This year, the economy is still growing strongly, labour market conditions have tightened and the dollar has weakened. The threat of inflation is more potent, which means that the central bank faces a larger dilemma.
The economy is no doubt sufficiently robust to survive a fair measure of financial turbulence. Mr Greenspan must also be concerned that moral hazard - the belief that the Fed is putting a safety net under the market following last year's 0.75 per cent crisis cut in interest rates - is contributing to high valuations on Wall Street.
But much will depend on the scale of any problem. Stephen Lewis, chief economist of London-based Monument Derivatives, argues powerfully that the Fed cannot allow historically high swap rates to deter it from tightening credit. Otherwise it would undermine confidence in the anti-inflationary thrust of Fed policy.
Yet a full-blown stock market collapse might be another matter. Mr Lewis also forecasts a very interesting month. He could well be right.
The Financial Times, August 13, 1999 |
