2013 risk repricing to be feared since last one in 2009 caused sovereign debt crisis
Over the American thanksgiving holiday three years ago in 2009, the relatively small sovereign-linked debtor Dubai World announced it would suspend payments on its debt obligations. Dubai World was a state-owned conglomerate in the emirate of Dubai, part of the United Arab Emirates, and at that time, a locus of serious property overbuilding. This event had a butterfly effect in the debt markets as it caused a tumultuous correction in the pricing of sovereign risk that ushured in a sovereign debt crisis worldwide. Now some investors are talking about 2013 as if there will be another risk repricing. Here are my thoughts on this possibility.
Since 2008, when governments moved into overdrive to shore up the financial system after the collapse of Lehman Brothers, we have lived in a market unusually characterised by massive risk-on and risk-off dislocations. Risk asset prices have been highly coordinated and asset classes have moved in concert with one another up or down to an unusual degree, sometimes violently as we have shifted between risk on and risk off. In my view, this owes in large part to the accommodative stances of central banks globally, where negative real interest rates are the norm rather than the exception.
Central bank action has come to dominate the investment landscape because the prospect of continued negative real interest rates has forced investors into riskier asset classes in a chase for yield. The fact that central banks are telegraphing their intention to maintain this accommodative stance has emboldened investors in their moves out the risk curve. However, when disruptive economic events occur, a rush to risk-off occurs violently as investors try to re-position themselves in the event central banks cannot maintain market liquidity in the face of the new economic events. Yet, time and again, we have seen that central banks have been able to smooth out the bumps in the road.
For example, early in the year, during my predictions for 2012, I wrote that “the ECB will then face a stark choice. Make their Italian backstop more explicit or go through a debt deflationary and depressionary crisis and cease to exist as an institution as the euro unwinds. I think they will choose inflation.” Here of course I meant asset price inflation and this is exactly what we saw when Mario Draghi started his outright monetary transactions program. With the Federal Reserve’s latest move to remain accomodative until the U.S. unemployment rate reaches 6.5%, we see a similar kind of move from the Fed, the goal being to calm nerves and prevent a move to risk-off due to uncertainty about future economic events.
Ray Dalio, the head of hedge fund Bridgwater Associates, believes that 2013 will be a year of risk repricing, meaning risk off. In the recent Dealbook Conference for Investors he made comments that followed the following logic train: interest rates are as low as they can go now. Austerity is here in Europe and is definitely coming to the US in 2013. With the economy already flagging, this will be a killer for the US and global economy and central banks won’t be able to stop it from hurting asset markets. Risk off will take hold and rates will push higher. The way John Carney put it at CNBC is that Ray Dalio is saying that in 2013 “the biggest opportunity will be shorting the bond market” with rising interest rates pushing down prices across the board, regardless of asset class – classic risk off.
Here’s the problem with that scenario: interest rates. I think most of this is plausible, meaning I have been predicting the US would go over the fiscal cliff all along. Moreover, I am on record since about 2009 as saying I didn’t see the U.S. being able to resist a move toward fiscal consolidation for more than 3 or 4 years because large scale deficit spending is just not politically sustainable. So I think the basic premise here makes sense. Moreover, Dalio has the other parts of the downturn right. Monetary policy will not be able to counteract fiscal in the US anymore than it has been able to counteract contractionary fiscal policy in Europe. So, the fiscal cliff will lead to serious economic pain, the amount of pain depending on how large the fiscal retrenchment is. And while it is still possible the U.S. could escape recession, I still believe that the fiscal cliff will result in recession in 2013. But with the Fed at zero percent, US government bond rates would plummet.
What we have seen time and again during this crisis is that the Fed has maintained its accommodation in the face of all events. Now they are saying nothing can move them from zero rates except a markedly lower unemployment rate – and the Fed is on record as saying that the unemployment rate will be between 7.4 and 7.7% in Q4 2013. So the Fed will be at zero for a very long time indeed. And with the Fed at zero, what we have seen time and again is that investors flee to Treasuries during periods when economic events call for risk-off. Interest rates go lower. And so I believe rates will go lower still if the Dalio scenario plays out. So Dalio’s scenario rhymes with mine from a macro standpoint. However, the big difference is that risk-off would mean lower yields not higher and this would not mean a wholesale repricing of risk assets as John Carney says in his piece at CNBC. I can’t know what Dalio himself actually said since I wasn’t at the conference. So I am just addressing John’s interpretation of Dalio here.
We can see this in Europe where German Bunds have played the role of Treasuries in the euro zone despite the currency user status that Germany holds. I believe Bunds have played the Treasury role in Europe because investors believe that for Germany would leave EMU and regain monetary sovereignty before they allowed the government to default. So Bunds are therefore still a risk-free asset as are Finnish and Dutch bonds to a lesser degree. But, crucially, even as the economy in Germany has turned down, with low yields, equities in Germany have not sold off. The Dax is at a one-year high. In fact, this is the Dax’s highest level since the beginning of 2008.
So, it takes more than just a bad economy to force a wholesale risk repricing that includes the so-called risk-free asset which serves as the anchor for discount rates and other asset classes.
A more plausible scenario is that risk assets sell off as the risk re-pricing causes risk premia to increase. That would mean asset classes like Student loan-backed asset backed securities, high yield bonds and equities would sell off while US Treasuries continue to act as a safe haven. The right trade in this scenario would be to be long Treasuries and short risk assets or simply long volatility as a hedge against one’s portfolio.
So if 2013 does see the US go over the fiscal cliff, the economy would stall and recession is the likely outcome. Even in a clifflet scenario, recession is possible. But this is simply not enough to cause a risk repricing. We would need a trigger event like Dubai World. Something like a student loan asset-backed security default to trigger a flight from risk assets and a general repricing of risk. Moreover, even as risk reprices, Treasuries will remain the risk-free asset and so while policy rates will remain at zero, expectations for future policy rates will ratchet down and long-term gvernment bond yields will come down accordingly.
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