Currency markets are healthiest part of warped financial system
‘It is time for bond and equity investors to become more vigilant’
International investors would be well advised to peruse the International Monetary Fund’s latest Global Financial Stability Report, published last week.
While the IMF acknowledges that the pickup in global growth, particularly in Europe, has “boosted market confidence”, it is increasingly concerned about the “build-up of financial vulnerabilities” stemming from the surge in private sector debt, dangerously stretched asset valuations and the acute challenge posed by the withdrawal of monetary stimulus.
Tobias Adrian, who heads the IMF’s financial stability watchdog, warned that exceptionally low levels of volatility and years of cheap money had bred complacency among investors and were “spawning financial excesses”.
Yet in global equity and bond markets, these warnings are going unheeded. According to EPFR Global, a data provider, global equity funds enjoyed more than US$6.5 billion of inflows in the week ending October 11, their largest ever weekly inflow. Global stock markets remain at record highs, with the Nikkei 225, Japan’s main equity index, surpassing the 21,000 mark for the first time since 1996. Meanwhile benchmark government bond yields stand at historic lows despite four interest rate hikes in the US since December 2015.
Clearly, equity and debt investors are not the least bit sensitive to risks and vulnerabilities in the financial system.
This is not the case for their counterparts in the US$5 trillion global foreign exchange (FX) markets. Currency investors are very sensitive – indeed hypersensitive – to financial, political and economic developments in both advanced and emerging economies.
While government debt markets used to be the vehicle through which investors expressed a view on global macroeconomic developments, currencies have been the most reliable gauge of sentiment ever since central banks’ ultra-loose monetary policies pushed down yields to unprecedentedly low levels, thereby desensitising bond investors to risks.
As HSBC rightly noted in a report last year, “in the past bond vigilantes would punish governments. Now with bond markets dominated by central bank buying, there is no room for this traditional reaction”. This “puts the onus on FX to punish the weak and reward the strong”.
Currency investors have become the new market vigilantes.
One of the clearest examples of this is the dollar. Having surged following Donald Trump’s election as US president in anticipation of a hefty fiscal stimulus package, the dollar index - a gauge of the greenback’s performance against a basket of other currencies - has plunged nearly 10 per cent this year partly because of the severe political woes of Trump which have undermined the prospects for meaningful tax reform.
The British pound, meanwhile, has become a political currency. Having plummeted 15 per cent versus the dollar in the four months following Britain’s shock decision in June 2016 to vote to leave the European Union, sterling has been extremely volatile over the past year, and has fallen 2.2 per cent over the past month as the UK’s negotiations with the EU over “Brexit” reach an impasse.
In emerging markets, the currencies of South Africa and Turkey, two of the most vulnerable developing economies, have borne the brunt of market concerns about both countries’ acute political and geo-political problems. While yield-hungry foreign investors have poured money into the countries’ local government debt markets over the past three years, the South African rand and the Turkish lira have fallen a staggering 24 per cent and 50 per cent respectively against the dollar since January 2015.
Yet while foreign exchange markets may be the healthiest, or sanest, part of a financial system heavily distorted by years of ultra-accommodative monetary policy, currency investors can also misprice risks.
The euro, which has surged more than 11 per cent against the dollar since mid-April (partly because of the sharp fall in the greenback), may not keep strengthening as much as markets predict. If the European Central Bank, which meets on October 26, ends up withdrawing stimulus much more slowly than investors anticipate, or if Italy - whose severe political and financial woes are a “crisis waiting to happen”, according to Deutsche Bank - becomes a major focal point of investor anxiety, the euro could start to weaken significantly.
More importantly, while foreign exchange markets may be sensitive to macro-political developments, asset prices are still likely to remain at dangerously high levels.
As long as equity investors remain upbeat about the prospects for global growth and corporate earnings, and bond investors believe leading central banks will keep monetary policy loose for a considerable period of time, the IMF’s warnings will continue to go unheeded.
It is time for bond and equity investors to become more vigilant.
Nicholas Spiro is a partner at Lauressa Advisory