Monday, July 17, 2006

ZIRP Redux

Stock and bond markets are very quiet today. Seems like no one wants to take a position ahead of inflation data and Bernanke's testimony. I'm still bearish, because I believe the Fed is more hawkish than the market currently suspects.

MBS and corporates were soft today, but volume is too light to draw much conclusion. TIPS underperformed by about 1 tick.

A followup on the ZIRP from the other day. I made the rather bold statement that if another LTCM-type event is coming, the ZIRP will be the culprit. Here is why I say this:

Active monetary policy, as practiced by all the major world central banks, is basically an attempt to interfere in the marketplace in a way that softens the impact of business cycles. Today, modern central banks generally view reducing price volatility as their primary objective. All but the most ardent of Libertarians agree that, in general, central banks have been quite successful in controlling inflation and the world economy has benefited from well-executed active monetary policy.

But make no mistake, when a central bank sets interest rates, they are artificially manipulating the price of money. The effect is no different than when artificial prices are set in the goods market -- there is either a shortage of supply or demand to meet the other. When New York manipulates rent prices lower through controls, the result is more people who want to rent than there are property owners willing to rent. Its no different in the financial markets. When the Bank of Japan is willing to loan at 0%, borrowers from all over the globe are lined up around the block.

From the borrower's perspective, its simple arithmetic. You have an investment that produces cash flow x. If you can borrow such that your interest cost y is less than x, borrow the money and make the investment. The more uncertain you are about x (i.e., it is risky), the greater you need (x - y) to be. So as y falls, the market takes more risk. If y is falling because of central bank manipulation, the likely result is that the market is taking more risk that would otherwise be the case.

Now let's say the central bank stops manipulating rates lower and allows rates to return to a natural equilibrium. Now the risks that were reasonable under yesterday's borrowing rate are no longer reasonable. The market for risky assets diminishes, and the marginal buyer of risk sees the value of his portfolio decline. Lately, this marginal buyer has been hedge funds.

At the same time that the market for risk is souring, let's say that a hedge fund experiences calls on its assets. Could be margin calls, could be investor withdrawals, or could be a duration mismatch on their assets and liabilities. Now they are forced to liquidate risk assets into a market that is already soft. The selling becomes self-feeding: the fund sells, the price of their assets falls because of the selling, the falling price causes more margin calls. Eventually, the fund is forced to close. If the fund is big enough and/or its trades are similar to many other funds, you have another Long Term Capital event.

No one can reasonably put odds on such an event, so I'm not going to try. We know that the U.S. Federal Reserve has moved their target rate from 1% to 5.25% and the financial markets have taken it in stride. What we don't know is how many risk buyers have survived elevated rates in the U.S. by borrowing in yen. I can say that anecdotally, I've heard borrowing in yen has been rampant.


Anonymous said...

That's a fascinating discussion, but I have to say, my sense of math brings me to disagree with one of your premises.

In the X = investment cashflow scenario, X has a given risk, that makes its premium over Y (interest cost), worthwhile. I would see no reason not to hold X constant, so that if the central bank lowers Y, X gains no risk. In fact, many investors who have a limited risk appetitite, might adjust their portfolio to be MORE risk-averse, because with the widening spread, they can afford to. If Y is lowered so that you can borrow at 0%, you can afford to make the same profit off Treasuries, that you before could reap from high-grade bonds. Other parts of the market will seek to pocket the additional profit, by holding their X investment constant. I do not see how the market is inclined to increase risk simply by the decrease in Y, other than simply in relative terms, Y being identified as the "risk-free" rate. But if X is constant, why should we not consider its risk constant as well? I would think the market is forced to take on riskier investments as the Central Bank drives up the rates, or else bear the impact of squeezing their profit spread. At some point, their risk appetite ends, and thus the Fed achieves what it wants, cooling the runaway market.


Anonymous said...

I already see flaws in my reasoning - the bond curve rises & falls with the Fed curve. Still, though, how does lowering Y implicitly push the market to take on more risk?

Accrued Interest said...

The greater the risk, the more expected profit an investor needs. The profit function is (x-y), so the lower y is, the more willing an investor is to take on risk.

Anonymous said...

Doesn't profit move independently of risk, in circumstances where the baseline of "risk-free" is moved? Or is all risk defined in terms of spread over the risk-free rate? (In which case profit would be determined solely by risk)

Accrued Interest said...

I'm assuming x is a constant (for a given investment) and y is the borrowing costs faced by the investor, not a RF rate.

Say you have two investments both with 8% expected return. The safer investment has a 1% standard deviation and the riskier has a 4% standard deviation. Say you can borrow at 7%. The safe investment has an 84% chance of being profitable. The risky investment has only 58% chance of being profitable.

So an investor buys the safe investment but not the risky one.

Now let's say the borrowing rate is 6% but the investment rates and risks remain the same. Now the risky asset has a 69% chance of being profitable. Now maybe the investor does both investments. The investor has taken more risk both because of what he's bought, but also that he's more leveraged.

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