Investor strategy: Credit market turmoil

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Richard McGuire, economist and fixed income strategist at RBC Capital Markets, answers readers’ questions on the current market turmoil, which markets are most vulnerable, how to establish profitable fixed income positions and the outlook for the global economy.

Do you think the credit crunch will bring many investment opportunities? For example, should Asian companies splash their money on American assets?
Liu, London

Richard McGuire: In terms of whether Asian companies should now be in a position to cherry pick cheap US assets, it would be premature to engage in such a strategy given that we see this as only the beginning of the re-pricing of risk across all asset classes - a development that also stands to see further dollar weakness over a short term horizon at least. Ultimately, given that markets do tend to overcorrect, there may well be scope for bargain hunting but we are a very long way from that stage.

Do you believe the current credit crunch is simply a (long over-due?) correction or the beginning of a bear market?
Anna Watson, London

Richard McGuire: The current credit crunch is both a long overdue market correction and, over the medium term, the beginning of a bear market. An abundance of liquidity in recent years (the product of carry trades, EM and oil producing country trade surpluses and sub-equilibrium policy rates in developed markets) has prompted a compression of risk premia which has driven a hunt for increasingly elusive yield. The recent rise in sub-prime defaults has thrown into relief the need to more accurately price risk which is at the heart of the current turmoil.

Just as recent years saw a positive performance on the part of all assets owing to this liquidity backdrop, its reversal (the seeds of which are being sown now) stands to see an underperformance of credit over the near term (as default risk is priced back in) but a outperformance of government bonds, particularly at the short end of the curve, as the market frets over tighter lending conditions feeding through into softer growth.

Ultimately, just as the recent buoyant liquidity was accompanied by low inflation (the China effect), its unwinding looks set to occur alongside higher global inflation rates (EM demand for commodities continuing, at least over the short term, even in the face of a US slowdown) which, ultimately, will prove bearish for bonds (at the longer end of the curve) and, via a higher risk free rate, a drag on equities.

I’d like to know what you see as the primary risks for SIVs and how these relate to wider financial market risks.
Rosario Ingles, London

Richard McGuire: SIVs are inherently risky owing to the very short term nature of their liabilities but the long-term nature of their assets. Consequently, they very quickly find themselves in the throes of a funding crisis when they are unable to roll over their short term commercial paper (such as is the case now).

In terms of how they relate to the wider financial markets, they are important in both a specific and a general context. Specifically, they exacerbate the current money market squeeze as banks are forced to make provisions for these vehicles being brought back onto balance sheets. In general terms, they are indicative of the fact that the current correction is a product not only of risk premia coming back into fashion but also a product of financial market innovation (for example, complex derivatives which while helpful in dispersing risk carry the added complication of obscuring where subsequent losses are being felt).

It seems that leveraged plays and its quick unwinding by hedge funds and others is the main trigger of latest financial crisis and instability. All investors are paying the costs of this extreme use of the balance sheet. Do you agree and would you favour a specific regulation that limits the use of leverage?
Marco Nordio, Sao Paulo, Brasil

Richard McGuire: Speaking from a UK perspective, I favour the FSA’s principle based system of regulation rather than one that is rule based. The former is much more useful in an industry which develops so quickly that specific regulations can soon become obsolete.

That said, there is arguably room for specific measures designed to limit the scope for the use of off balance sheet vehicles such as SIVs which are inherently risky owing to their borrowing at very short maturities to enter into long-term investments. An alteration of their tax efficient status offers some appeal. In broader terms, however, investors have reaped enormous benefits from leveraging in recent years and I would be wary of setting limits on leverage now that losses are being incurred.

Why do you think the Bank of England keeps insisting that the problem in term Libor is a counterparty credit problem among banks rather than what it so obviously is - a banking system balance sheet problem? Do you think that the current crisis is helping the Bank of England out by a) tightening monetary conditions and b) tightening consumer lending conditions, while neatly disculpating the Bank itself?
Justin Knight, UK

Richard McGuire: A reappraisal of the riskiness of structured credits (prompted initially by losses relating to the sub-prime mortgage market) has resulted in a self-reinforcing reaction whereby lenders are wary of extending short term loans (owing, in part, to concerns over the health of the collateral offered) which, via the impact upon off-balance sheet vehicles which depend on short-term financing (so-called conduits & SIVs) has seen banks hoard liquidity in order to make provision for positions that will, eventually have to be brought back onto balance sheets.

This latter development, in turn, sees lenders unwilling to provide liquidity to others. Hence it is both a counterparty AND a balance sheet problem and one that, arguably, is not related to a lack of liquidity but a superabundance of it (this liquidity encouraging excessive risk taking which is now being reversed). The Bank of England is right in that a change in the policy rate to ”unfreeze” the money markets is not the answer to the problem. Ultimately, though, the Bank will have to act if the dysfunctional nature of the money markets filters through in the form of a tightening of more general lending conditions - the risk of which grows the longer the crunch continues.

What’s the macroeconomic status in the US? Would a rate cut in the US help the credit market?
Lise Anderson, Stockholm, Sweden

Richard McGuire: The US is headed for a period of discernibly sub-trend growth as the ongoing, and marked, correction of the housing market weighs on the consumer. To date, a buoyant labour market and a strong performance on the part of equities has seen the consumer somewhat insulated from the housing market slowdown.

Last week’s non-farm payrolls data, however, pointed to a softer tone in the labour market which, in turn, is a concern as rising joblessness is a catalyst for housing correcting via falling prices rather than lower turnover. While recession is not our base case scenario, the risk of such an outcome is not insignificant. I would argue that the Fed’s ability to shore up the credit market via lower policy rates is limited - the problem lies with a reappraisal of counterparty risk, a concomitant wariness of collateral and, by extension, a freezing of the money markets.

Arguably, it is only when lenders are aware of the losses suffered by potential counterparties as a result of this risk reappraisal that the availability of short term borrowing will improve. However, that said, the market is priced for an aggressive easing of Fed policy so that while a cut might not prove the solution to the credit market’s woes, a steady rate decision on September 18 would clearly make matters worse.

As a repercussion of the subprime crisis will the ten-thirty year segments of the government curve flatten or steepen? Will the effects be the same on the Euro curve as on the USD curve?
Jens Hoiberg-Nielsen, Italy

Richard McGuire: Assuming, as we do, the Fed will cut rates on September 18, curves globally will continue to steepen markedly, led by the short end and with the 10s-30s sector also steepening (albeit to a lesser degree. Over the near term this will be a bullish move. However, against a backdrop of a step up in global price pressures (EM demand supporting both hard and soft commodities) we see the next phase of steepening being bearish in nature - the market fretting over the Fed having opted to sacrifice lower inflation in favour of a shoring up growth.

In either scenario we see the Euro curve (10s-30s) lagging the US-led steepening move both due to the fact that growth concerns are more acute in the US (Europe is not burdened by the same imbalances) and, given the ECB’s evidently greater focus on tackling price pressures, inflation is likely to ultimately be seen as more of a risk in the US than in Europe. In short, expect an outperformance near term in US 10s vs. Europe when growth concerns dominate but an underperformance subsequently as inflation fears take over.

Given the interest rate turmoil and the dependence of so many hedge funds on carry trades, how do you see this feedback loop affecting both hedge funds and interest rates, internationally?
Borzou Aram, London

Richard McGuire: The current re-pricing of risk premia and the associated rise in volatility are, in broad terms, symptoms of the unwinding of the ”conundrum” of low long-term yields seen in recent years. The receding of liquidity implicit in the paring back of carry trade demand will, ceteris paribus, put upward pressure on bond yields.

Over the near term, a likely offsetting boost to liquidity in the form of lower policy rates (the Fed looking set to ease on September 18) will see lower yields across the curve, led by the short end, the decline in liquidity via diminished carry trade demand forms part of the rationale behind our expectation the US curve will eventually bear steepen.

In terms of hedge funds, themselves, I think it would be wrong to overemphasise their dependence upon carry - after all, those funds that have opted to short carry trades will have found this to be a profitable strategy.

Do you think that steady inflation will force China to take a more drastic step with their currency rate against the dollar.

Richard McGuire: While allowing a faster appreciation of the renminbi would prove the most effective means of damping Chinese activity and addressing, what Chinese officials themselves admit to, is an overheating economy, the authorities’ preference for employing the arguably blunt instruments of policy rates and reserve requirements is indicative of their desire to avoid paying more than token lip service to exchange rate liberalisation.

Ideologically, it would be difficult to relinquish too much control of the economy to market forces, not least owing to the fact that full employment is a key justification for the government’s existence. The threat to a fragile banking system implicit in a more rapid appreciation of the exchange rate similarly argues in favour of using administrative measures to contain price pressures. Against this backdrop, the likelihood of China placing increasing emphasis on the exchange rate as a demand management mechanism is, at best, slim.

About the expert

Mr McGuire is senior fixed income strategist with Global Directions trading team at Royal Bank of Canada. Prior to this, he was a senior economist within Dun & Bradstreet’s sovereign ratings arm. Global Directions, a mini hedge fund within RBC, looks to establish profitable fixed income positions within core markets - Canada, the UK, Europe, the US and Australia and New Zealand - and with the rationale for these trades being derived from RBC’s fundamental macroeconomic view of the world.

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