Liquidity, a fundamental
concept in finance, can be defined as the ability to buy
or sell large quantities of an asset quickly and at low
cost. A liquidity crunch is the main cause of financial
cycles of boom and bust. Financial cycles are different
from business cycles in that they are predominantly
driven by liquidity and illiquidity. Financial cycles
are the dominant force in finance capitalism, replacing
the business cycles in industrial capitalism.
In
a bubble economy, asset values are inflated beyond the
level supported by the money supply. The abrupt
monetization of assets in a crisis requires large
amounts of ready cash in the financial system. But cash
is among the lowest-yield financial instruments that are
expensive to hold. Thus the main source of cash in times
of crisis is always the central bank, which can issue
money at will and at no monetary cost, at least for the
US. Other central banks cannot issue dollars, the
currency of choice in international finance. They cannot
issue money even in their own currencies without the
penalty of exposing their currencies to speculative
attacks because of dollar hegemony. The vast majority of
equilibrium asset pricing models do not consider trading
and thus ignore the time and cost of transforming
financial assets into cash or vice versa. The history of
recent financial crises suggests that at times market
conditions can be so severe that liquidity can decline
or even disappear temporarily. Such liquidity shocks are
a potential channel through which asset prices are
influenced by liquidity.
Bond of
bother The current yield environment more closely
resembles 1994 than 1987. In 1994, the bond market was
caught on the wrong side of economic fundamentals by the
Fed's low-interest policy and crashed with Fed policy
reversal toward higher rates. But unlike 1987, the stock
market was spared in 1994 because money merely left
bonds for stocks. Yet stock prices eventually need to be
supported by corporate earnings, which will be the
Achilles' heel of any equity bubble because rising
interest rates tend to dampen corporate earnings. In a
situation when both bonds and stocks face price
collapse, market participants may simply hold on to cash
in an attempt to preserve capital. In that case, central
banks face what Keynes calls a liquidity trap and become
impotent in curing a financial crisis with added
liquidity. The last victim of a liquidity trap was Japan
in the late 1990s when banks could not find creditworthy
borrowers, even with negative interest rates.
For 2004, many traders view the rout in bond
prices as merely the unwinding of an overbought
unbalance caused by interest rates staying too low for
too long. Bond portfolios are mostly still above water
for the year, although they lost much of their earlier
gains. By historical standards, the rise in interest
rates since June 13 can be considered extreme, at least
in percentage terms.
The policy of using
interest rate cuts to pump up demand incurs economic
costs, as evidenced first in Japan and then recently in
the US. The costs include the danger of structural
damage to long-cycle finance institutions such as those
in the insurance sector. The soundness of these finance
institutions can be threatened by abnormal spreads
between short and long-term interest rates as well as by
the adverse effect of new debts on the value of
outstanding debts. There is also the question of
sustainability and subsequently re-igniting inflationary
pressures. In other words, the Fed's low interest
strategy between 2000 and 2003 might have led to a bond
bubble similar to the equity bubble of the 1990s, and
its subsequent reversal on interest strategy creating
conditions that ensure the bond bubble will burst.
Long-term yields have fallen to a level that
requires a prolonged period of price stability or
deflation to justify. Five-year yields slightly above 2%
require zero inflation in the US economy over the next
five years, a clearly unlikely scenario, particularly so
with commodities and oil. US bonds have risen further
and faster than at any stage in the past 40 years, a
phenomenon that looks jarringly like the Nasdaq run-up
of the late 1990s which hit its all-time high on March
10, 2000 at 5132.52. The heavily tech-dependent index
would fall more than 77.8% in the three years after the
bottom dropped out of the so-called Internet bubble. It
now hovers around 1900. Since February 2000, the decline
in five-year yields is down from 6.76% to 2.08%, which
was greater in percentage terms (68%) than the 59% drop
from September 1981 to August 1986 that set the scene
for the 1987 crash.
Before 1994, short-term
rates fell from 8% to 5% only to climb back to 8% again.
Today, 10-year yields have risen from below 3.5% to over
4% and can rise above 5% over an 18-month period. Yet
volatility seems built into the market. Ten-year yields
again fell below 4%, hitting 3.984% on October 22, 2004.
Unsophisticated investors traditionally are lured into
bonds as a safe investment when in fact the potential
for capital loss in bonds is just as great as in
equities in the new economy. Bonds tend to produce a
lower return because they are perceived to be less risky
than equities. Yet on a three- or five-year view ahead,
this perception will be wrong due to the Fed's interest
rate vicissitudes. There is at least a possibility of
10-year bonds falling by 25% over the next 18 months as
there is of shares falling by the same amount. The
threat to bonds even if there is no resurgence of
inflation will be that other investments will outperform
them in a neutral interest rate environment, putting
downward pressure of bond prices. Yet most investors in
bonds do not have that same awareness of risk as equity
investors.
The consequences of a bond market
crash are complex and generally not well understood.
That it hurts pension funds and forces governments to
borrow at higher rates is obvious. Less obvious is that
it also distorts bank balance sheets and is lethal to
the financial sector. US Fed chairman Alan Greenspan has
expressed the view that markets are now more
sophisticated and better hedged than in 1994. But the US
now depends more on foreign savings. The market for
mortgage-backed securities has tripled in a decade to
$4.7 trillion. Participants in that market hedge their
bets in the bond market, amplifying bond market moves.
Even slight interest rate moves by the Fed may have a
bigger and less predictable impact as a result.
Swap to power The US twin deficits are
showing no signs of abating with Greenspan reassuring
the market that the US economy is in "reasonably good
shape". Derivatives such as total return swaps (TRS) can
make short-term dollar loans (liabilities) appear as
portfolio investments (assets). Also, the requirement to
meet margin or collateral calls on derivatives may
generate sudden, large foreign exchange flows that would
not be indicated by the amount of foreign debt and
securities in a nation's balance of payments accounts.
As a result, the balance of payments accounts no longer
serve well for assessing country risks. As China
liberalizes it credit markets, or pushes the yuan into
the global credit markets, its $450 billion-plus foreign
exchange reserves will appear less significant as a
hedge against speculative attacks on the yuan.
In the event of currency devaluation or sharp
downturns in securities prices, derivatives such as
foreign exchange forwards and interest rate swaps and
TRS function to quicken the pace and deepen the impact
of the crisis. Derivative transactions with emerging
market financial institutions generally involve strict
collateral or margin requirements. The rate of
collateralization is estimated at around 20% of the
notional principal of the swap. If the market value of
the swap position were to decline, the East Asian firm
would have to add to its collateral in order to bring it
up to the required maintenance level.
Thus a
sudden sharp fall in the price of the underlying
security would occur at the beginning of a devaluation
or a broader financial crisis would require the Asian
firm to immediately add dollar assets to its collateral
in proportion to the loss in the present value of the
swap positions. This would trigger an immediate outflow
of dollar reserves as local currency and other assets
are exchanged into dollars in order to meet the
collateral requirements. This would not only quicken the
pace of the crisis, it would also deepen the impact of
the crisis by putting further downward pressure on the
exchange rate and asset prices, thus increasing losses
to the financial sector. An upward revaluation of the
yuan may well produce such instability all over Asia.
The EU's GDP is now greater than the US's. Yet
the euro economy is still much smaller than the dollar
economy due to dollar hegemony. The pool of euro-dollars
(off-shore dollars) in circulation is now larger that of
dollar circulation within the US. The introduction of
the euro led to a surge in euro-denominated bond issues,
and this in turn boosted arbitrage and hedging activity
by issuers, dealers and investors. Participants in
European markets began to use interest rate swaps to
hedge their holdings of non-government bonds in the
early 1990s, several years before participants in the
dollar and other markets began to do so. At that time,
financial institutions were the dominant non-government
issuers in European markets, and as a result quality
conditions in the non-government bond market were
similar to those in the swap market. Participants in
European markets thus became accustomed to hedging
credit products with swaps.
The growth of the
euro swap market was driven by hedging and positioning
activity. Following monetary union, swaps quickly gained
benchmark status in euro financial markets, displacing
some of the benchmarks in the legacy currencies as the
locus for price discovery about future short-term
interest rates.
The fragmented nature of
European government securities markets strengthened the
incentive to switch to swaps for speculating on and
hedging against interest rate movements. The market for
unsecured inter-bank deposits was among the first euro
financial markets to become integrated and, given that
swap rates embody expectations of future inter-bank
rates, this contributed to the rapid integration of swap
markets in the euro legacy currencies. In fact, a single
euro swap curve emerged almost overnight. Therefore,
short positions - those taken in expectation of an
increase in interest rates - can be created with
relative ease in the swap market by choosing the "pay
fixed" side of a swap.
In contrast, the secured
market, specifically the general collateral repo market,
was slower to break out of the segmentation that
characterized it prior to monetary union. Differences in
governments' credit ratings, settlement systems, tax
regimes and market conventions remain obstacles to the
complete integration of euro government securities
markets. As a result, a single market for general
collateral repos does not yet exist; market participants
must still specify the nationality of government debt
used as collateral before they conclude a repo
transaction. This complicates the use of government
securities to hedge or speculate on interest rate
movements.
The switch to swaps was reinforced by
a series of traumatic market events in the late 1990s.
Events surrounding the near collapse of Long-Term
Capital Management in September 1998 highlighted the
risks inherent in the use of government bonds and
related derivatives to hedge positions in non-government
securities. This had been a routine strategy among
dealers up until that time, albeit more so in the dollar
market than in the euro market.
Squeezes in
German government bond futures contracts over 1998-2002
had a similar effect. Temporary increases in the
scarcity premium on euro government securities during
auctions of third-generation mobile telephone licenses
in 2000 also made government securities less attractive
for hedging and position-taking purposes.
Overnight index swaps (OISs) have become
especially popular hedging and positioning vehicles in
euro financial markets. An OIS is a fixed-for-floating
interest rate swap with a floating rate leg tied to an
index of daily inter-bank rates. In the euro market,
OISs are overwhelmingly referenced to the euro overnight
index average (EONIA) rate - a weighted average of
interest rates contracted on unsecured overnight loans
in the euro area inter-bank market. Trading in EONIA
swaps is highly concentrated in maturities of three
months or less, and EONIA swap rates are widely
considered to be the preeminent benchmark at the short
end of the euro yield curve. Banks, pension funds,
insurance companies, money market mutual funds and hedge
funds all make extensive use of EONIA swaps to hedge and
speculate on short-term interest rate movements. OISs
are also traded in US dollars and other major
currencies, but they have not gained benchmark status in
these markets.
The benchmark status of the euro
swap curve is reflected in quoting practices for
corporate bonds. These practices often depend on the
credit quality of the issuer and the nationality of the
investor. Euro-denominated bonds issued by investment
grade borrowers are usually quoted in terms of a spread
over the swap curve. For non-investment grade corporate
bonds, prices are quoted in the form of outright yields.
Interest rate swaps are becoming more widely used as
benchmark instruments in the US dollar market too.
However, the shift is less advanced than in the euro
market. For example, many US investors still prefer to
price dollar-denominated corporate bonds against the
treasury yield curve rather than the swap curve.
Notwithstanding the growth of the euro swap
market, futures contracts continue to be heavily used as
hedging and positioning vehicles. Indeed, trading in
euro-denominated money and bond market futures soared in
the run-up to and years immediately following the
introduction of the single currency. Contracts based on
three-month Euribor - a trimmed average of interest
rates quoted for term deposits in the euro area
inter-bank market - and traded on the London
International Financial Futures and Options Exchange
(LIFFE) are by far the most actively traded short-term
interest rate futures in the euro market. Contracts
based on German government securities and traded on
Eurex dominate activity in longer-term euro futures.
The growth of the euro swap market has been
accompanied by greater diversity in the range of players
using interest rate swaps. In the run-up to European
monetary union, the inter-dealer segment drove the
growth of the euro swap market. At end-1998, positions
vis-à-vis other dealers accounted for 52% of the
outstanding notional amount of euro interest rate swaps
and forwards. Since 1999, the dealer-customer segment
has become increasingly important. By end-June 2002,
positions vis-a-vis financial customers accounted for
42% of the outstanding notional amount of euro interest
rate swaps and forwards, and positions vis-a-vis
non-financial customers a further 7%. By comparison, in
the dollar swap market, positions vis-a-vis financial
customers accounted for 41% of outstanding contracts,
and positions vis-a-vis non-financial customers 15%. The
smaller share of the dollar swap market accounted for by
inter-dealer positions - 45%, compared to 51% in the
euro market - is explained in part by greater
concentration in the dollar market, which results in
dealers offsetting more of their transactions internally
rather than with other dealers.
Even European
governments have begun to use interest rate swaps to
manage their risk exposures. The French government has
since October 2001 employed swaps to shorten the average
maturity of its debt. As of end-July 2002, it had
written swaps totaling 61 billion euro in notional
principal, equivalent to approximately 8% of the
outstanding French government debt. The German
government uses swaps to lower its interest costs. At
present, it is authorized to swap up to 20 billion euro,
equivalent to about 3% of its outstanding debt. The
Dutch, Italian and Spanish governments are also active
in the euro swap market. The entry of governments into
the interest rate swap market has tended to put a
ceiling on euro swap spreads.
Although the range
of players using swaps is increasing, the number of
intermediaries is declining. Swaps are overwhelmingly
traded over the counter (OTC), and so dealers are
critical to the functioning of the swap market. Given
customers' traditional preference for dealing with
high-quality counterparties, trading in OTC markets has
long been dominated by a handful of better-rated
dealers. In particular, the major dealers have tended to
be commercial banks with credit ratings of at least
double-A.
In recent years, intermediation in OTC
markets has become even more concentrated owing to
mergers and acquisitions. For example, following the
merger of Chase Manhattan and JP Morgan in 2000, the
combined entity's share of the global OTC interest rate
derivatives market equaled approximately 25%. In the
EONIA swap market, the five largest dealers accounted
for 48% of all trading activity during the second
quarter of 2001 and the 20 largest dealers 88%. Other
segments of the euro interest rate swap market were more
concentrated, with the five largest dealers accounting
for 60% of turnover. The euro swap market, however, is
less concentrated than the dollar market. Two banks hold
nearly three quarters of all interest rate derivative
contracts booked by US banks, and the five largest banks
hold over 90% of outstanding contracts.
Banks
headquartered in the euro area are the most active
dealers in the euro swap market, writing 46% of notional
contracts outstanding in end-June 2002. Among euro area
banks, German banks are the largest dealers, with a 21%
market share, followed by French banks at 15%. US banks'
share of the euro swap market was 35% at end-June 2002.
In comparison, US banks' share of the dollar swap market
was 54%. Japanese banks play only a marginal role in the
euro and dollar swap markets but have a 33% share of the
yen market.
The pricing of interest rate swaps
in general depends on the interest rate used for the
floating rate leg of the contract. The yield used for
the fixed rate leg is supposed to embody expectations
about the future path of the floating rate for the life
of the contract and the risk associated with the
volatility of that rate. For euro swaps, the choice of
the floating rate tends to depend on the contract's
maturity. For short-dated swaps, EONIA is the most
common basis for the floating rate leg. Euribor was
commonly referenced following monetary union but by
2000, had been superseded by EONIA at the short end of
the swap curve. For longer-dated swaps, Euribor remains
the key reference rate. The underlying instruments for
both EONIA and Euribor are unsecured interbank deposits
and therefore these rates reflect a degree of credit
risk. Indeed, most banks in the EONIA and Euribor
contributor panels are rated double-A.
The
pricing convention for euro swaps is to provide quotes
in terms of the yields that specify the fixed payments
for the contracts. This is unlike the convention for US
dollar swaps, which are typically quoted in terms of
spreads over US treasury yields. Hence, the price of a
five-year euro swap might be quoted as 4%, without any
reference to a government bond yield, while that of a
five-year US dollar swap might be quoted as 50 basis
points over the five year US treasury yield. To be more
precise, quoting in spreads for dollar swaps is
conventional for dealers in New York, while quoting in
yields for this contract would be more typical for
dealers in London. EONIA and Euribor are the most common
reference rates. Swap rates include a premium for
counterparty risk
In spite of the benchmark
status of euro swaps, their yields still tend to hover
above the yields for the most liquid triple-A rated
government bonds in a given maturity, just as dollar
swap yields tend to be higher than US treasury yields.
At the 10-year maturity, for example, the fixed rate on
euro swaps at end-January 2003 was about 20 basis points
above the yield on the German bund. Swap rates are
typically higher than rates on triple-A rated securities
because they contain a premium for counterparty credit
risk, which is often associated with the major dealers
in the market.
Alternatively, deterioration in
the perceived creditworthiness of the government could
result in a narrowing of the spread. For example, fiscal
difficulties in Germany appeared to contribute to a
narrowing of the spread between euro swaps and German
government bonds in 2001 and 2002. In the past, a
customer could mitigate counterparty risk by spreading
positions across several dealers. As consolidation in
the financial industry reduced the number of active swap
dealers and credit ratings of the remaining dealers were
downgraded, daily settlement and especially
collateralization became increasingly common. The
widespread use of such mechanisms for mitigating
counterparty risk resulted in narrower and more stable
swap spreads.
Nevertheless, counterparty risk
can still at times unsettle the swap market. For
example, credit concerns about several large US banks -
including major derivatives dealers - caused dollar and,
to a lesser extent, euro swap spreads to widen in July
2002. Other possible influences on swap spreads include
the general level of interest rates and the slope of the
yield curve. However, the economic rationale behind
these factors is difficult to explain, and their
relationship with spreads tends to be unstable over
time. Liquidity was a concern in the past but liquidity
in the euro swap market is now such that yields tend not
to be driven by imbalances in supply and demand.
Rising Europe European swap markets
were already quite liquid prior to monetary union, and
they gained liquidity following the introduction of the
single currency. The use of interest rate swaps by some
market participants as hedging and positioning vehicles
increased the willingness of other participants to do
likewise, resulting in a self-reinforcing process
whereby liquid markets become more liquid.
A
liquid market is one where participants can rapidly
execute large-volume transactions with a small impact on
prices. There are at least three dimensions to market
liquidity: tightness, depth and resiliency. Tightness
refers to the difference between buying and selling
prices. Depth relates to the size of trades possible
without moving market prices. Resiliency denotes the
speed with which prices return to normal following
temporary order imbalances. Collateralization is
increasingly common.
Euro swaps are one of the
most liquid instruments available in euro financial
markets. Indeed, EONIA swaps are the most liquid segment
of the euro money market. EONIA swaps of 2 billion euro
are regularly traded in the inter-dealer market for
maturities up to three months, and significantly larger
trades are not uncommon. Bid-ask spreads are typically 1
basis point. The Triennial Central Bank Survey of
Foreign Exchange and Derivatives Market Activity shows
that the average daily turnover of euro-denominated OTC
interest rate contracts almost doubled between April
1998 and April 2001, to 231 billion euro. Compared to
the $56 trillion in notion value of dollar derivative in
2002, the euro derivative market is still miniscule.
By 2001, the turnover of euro swaps and forwards
exceeded that of all interest rate products other than
money market futures, US treasuries and German
government securities. Trading in EONIA swaps appears to
account for much of this growth. Beyond two years,
however, the euro swap market is neither as tight nor as
deep as the larger European government securities
markets. Anecdotal evidence suggests that bid-ask
spreads for euro swaps are wider than those for
government securities: one basis point for inter-dealer
swaps, compared to less than half a basis point for the
most recently issued German government securities. Quote
sizes are also smaller: approximately 100 million euro
for five and 10-year swaps, compared to at least 150
million euro for the most recently issued German bobls
(or Bundesobligationen) and bunds. Trading activity in
longer-dated swaps is a fraction of that in futures
contracts on German government bonds.
Moreover,
liquidity in the euro swap market appears more likely to
evaporate during periods of extreme volatility than
liquidity in the larger government securities markets.
In particular, interest rate swaps remain less liquid
than they would be if they were traded on an organized
exchange, where a central clearing house could act as
the counterparty to all trades. Counterparty credit risk
becomes of paramount concern during periods of market
volatility, when uncertainty about the health of
financial institutions often increases. Consequently,
arrangements for dealing with counterparty risk play a
major role in determining market liquidity under stress.
Assuming that the soundness of the clearing
house is ensured, the liquidity of instruments traded on
organized exchanges tends to be more robust to stress
than that of instruments traded over the counter. Steps
have been taken to encourage greater centralization in
the swap market. In the early part of 2001, the London
Clearing House, supported by several of the largest swap
dealers, began clearing and settling interest rate swaps
in all of the major currencies. At about the same time,
LIFFE introduced futures contracts on two-, five- and
10-year euro swaps. However, trading of swap futures
accounts for an insignificant proportion of global swap
activity. In contrast, trading of futures contracts on
German government bonds accounts for the larger part of
activity in the German government securities market.
EONIA swaps are the most liquid segment of the euro
money market, but government securities markets are more
liquid at longer maturities.
It remains unclear
whether swaps will continue to erode the benchmark
status of government securities and consolidate their
position as the dominant positioning and hedging
vehicles in euro fixed-income markets. In addition to
the previously mentioned concern about counterparty
risk, another concern is that the participation of
large, one-sided players such as governments could
increase the risk of idiosyncratic movements in swap
yields - ie it could increase basis risk - and so make
swaps less effective hedges.
Repos could
eventually compete with EONIA swaps for benchmark status
at the short end of the euro yield curve, as they do in
the US dollar market. European repo markets are growing
rapidly and steadily becoming more integrated, boosted
in large part by market participants' efforts to limit
counterparty credit exposures. The development of a
tri-party repo market - in which settlement and
management of the collateral is delegated to a central
clearing house - is especially noteworthy because it
allows a basket of securities to back a transaction,
including lower-quality, less liquid securities. At the
longer end of the yield curve, government securities
remain attractive benchmark instruments, not least
because of the tremendous liquidity of German government
futures contracts.
It seems the one thing that
emerges from a discussion on the relationship of
interest rate to inflation is that clear definitions of
economic condition are necessary to fully understand or
describe such relationship. Although it is not a
derivative instrument until it is structured as a swap,
interest is a derivative whose value is derived from the
amount of the loan principal and the interest rate. The
interest rate determines the amount of interest to be
paid over time on a principal sum that in turn
determines the size of the cash flow. The total cash
flow in a financial system reflects its liquidity. Thus
interest rate has a direct effect on liquidity.
In a debt-free economy, interest rate is
irrelevant because with zero principal, the interest
payment is also zero, regardless of the interest rate.
In a saturated debt market, as in Japan now, the
interest rate is also relatively irrelevant because all
outstanding loans are mostly likely fully hedged and new
loans are not being written for lack of demand or
creditworthiness common in a liquidity trap. The zero
interest rate in Japan has little impact on the economy
because qualified borrowers cannot be found even at
negative rate. In other words, outstanding bad loans
have already absorbed all available collateral.
Thus it follows that the impact of interest rate
on inflation is a function of the size of the aggregate
debt in an economy in relation to the market value of
the collateral. Aggregate demand for new debt is a
function of surplus collateral which is in turn a
function of market value. A sudden and drastic fall in
market value increases the loan to asset ratio and
depletes surplus loan to asset ratio. Therein lies the
detonator for implosion of a debt economy in a bear
market.
What is a bear market? Price is no doubt
the intended intersection of supply and demand, provided
supply and demand are defined broadly without excluding
externalities. But price does not always lead to
transactions. And only transactions make a market, not
price. There is sometime a price with no market when the
asking price is stubbornly too high to attract buyers.
In an open market, technical analysts will tell you that
when an item is put up for sale, the price is not set by
the seller or the potential buyer. Price is the result
of open bids, adjusted according to the degree of market
friction. What produces a bear market is the absence of
bids, the seller in a non-monopoly then lowers the
asking price out of fear that another seller may steal
the sale. Potential buyers hold back in hope for a more
desperate seller. Thus a bear market emerges. Sellers do
not compete with buyers, but with other sellers, the
same being true with buyers.
A bull market is
created by reverse dynamics. Buyers pay asking price or
offer above asking price out of fear of losing the deal.
Sellers hold back for better offers from competing
buyers. If the upward price pressure is greater than
interest cost, potential sellers will borrow against the
asset rather than sell. This tends to increase the
market value of the asset, qualifying it for additional
loans, which in turn pushes prices up further. This is
what is known as the wealth effect on debt. This spiral
could go on forever if it were not for the little
problem of interest payment. Loans are not allowed to
postpone interest payments. When that happens it is
called a default, the worst word in the credit business.
Just as the concept of forgetfulness depends on the
concept of memory, the notion of debt is dependent on
its service and repayment. A debt without the support of
regular or pre-arranged interest payment or the prospect
of principal amortization turns into a loss. Thus loans
rely not just on collateral, but also on the cash flow
that the collateral or other assets can generate for
servicing the loan by paying interest periodically or at
an agreed time. This little convention prevents the
existence of perpetual bubbles.
There will come
a point when the cash flow capacity of assets will fail
to support the interest payments on a ballooning loan
perfectly secured by the underlying assets' rising
market value. When that happens, the borrower must sell
to reduce his debt and the upward price pressure peaks
and starts reversing itself as downward price pressure.
The bull market then abdicates and the bear market takes
over. The nature of the credit market is such that the
downward slide is much more forceful and speedy than the
upward climb. The rapid downward slide is called a burst
of the debt bubble or a debt collapse.
Now,
history has shown that two related developments could
under normal conditions prevent or soften a debt
collapse. They are, first, a sufficient and timely
increase of the money supply by the central bank and
subsequently reflation that is brought about by
increased money supply in a no-growth or negative-growth
economy, or inflation which is caused by a money supply
growth rate ahead of economic growth rate.
Anatomy of money supply The money
supply then is of critical importance to monetary policy
considerations. To monitor the money supply, the Fed
tracks three monetary aggregates, M1, M2, and M3, each
of increasing scope but decreasing rate of turnover. M1
comprises the traditional definition of money as a means
of payment. It includes currency in circulation plus the
checkable deposits in depository institutions (banks and
thrifts). Currency in bank vaults and bank deposits at
the Fed are not a part of M1, although they are part of
the monetary base, sometimes designated M0. M2 includes
M1 plus retail non-transaction time deposits. M3
includes M2 and wholesale deposits. Each of these money
aggregates serves a different purpose for Fed
deliberations. At the end of August 2004, M1 measured
$1.34 trillion; M2 measured $6.3 trillion and M3 $9.28
trillion, which increased by $390 billion over the $8.89
trillion measured at the end of August 2003. Yet the
latest available data on notional values of dollar
derivative is $56 trillion for 2002, up from $45
trillion in 2001. The figure could reach $65 trillion
for 2003 that would be more than seven times the M3.
Too much money in relation to the output of
goods and services leaves money idle and tends to push
interest rates down and push prices and inflation up.
Inflationary growth in turn requires more money to
sustain growth. Too little money tends to push interest
rates up, lowers prices and output and causes
unemployment and idle plant capacity, which in turn
further reduces demand for money. There was a time when
the money in deposits with commercial and saving banks
roughly equaled to loans outstanding in the economy. The
Fed, through setting the cost of funds (interest rate),
partial reserves and capital requirements for banks,
could manage the rise and fall of the money supply.
The Fed still attempts to manage the money
supply by setting bank reserves and the discount rate at
which banks borrow to meet their reserves needs, as well
as Open Market Operations to achieve Fed funds rate
(ffr) targets by trading government securities to inject
or drain money in the banking system. The Fed also
participates in the repo market to keep the repo rate in
line with the ffr. Repos allow banks to skirt the
reserves requirement when expanding their loan
portfolios. Banks often do not even own the government
securities they use to execute repos, the proceeds of
which yield banks such interest rate spread from bank
loans that the cost of borrowing the government
securities are more than covered.
With
deregulation, all money except cash has become interest
bearing. And with Automatic Teller Machines (ATM) and
credit card use, the amount of cash needed in the
economy has shrunk dramatically. Everyone is operating
with just-in-time cash management. M2 is overnight
repos, overnight eurodollars, savings accounts under
$100K and money market mutual fund shares. M3 is M2 plus
time deposits over $100K and term repos. Finally, L
(Long-term liquid funds) is M3 plus T-bills, savings
bonds, commercial papers, bankers acceptances and
eurodollar holding of US residents (non-bank).
Derivatives are not included in money supply data.
With the growth of securitization, banks pass
off their loan portfolios to investors in the credit
markets. In this process, banks act as reverse
intermediaries from their traditional retail role in
both deposit and loans and become retail marketers of
loans to feed a wholesale credit market. This credit
market is totally outside the control and jurisdiction
of the Fed. Tax deductibility of interest on home
mortgages, interest on margin accounts, interest on
loans for corporate mergers and acquisitions affects
significantly the impact of interest rates on inflation.
Risk business Risk arbitrage is a
risky play to profit from the simultaneous purchase of
stock in a company being acquired and sale of stock in
its proposed acquirer. It is also known as takeover
arbitrage, a play that profits by cashing in on the
expected rise in the price of the target's shares and
drop in the price of the acquirer's price. The risk is
if the takeover falls through for any number of reasons,
the arbitrageur may be left with huge losses. Risk
arbitrage differs from risk-less arbitrage, which
entails locking into profit from differences in the
prices of two securities or commodities trading on
different exchanges. Risk arbitrage is done through
credit, using the current market value of the shares as
collateral.
Risk aversion is not just an
attitude, it is a calculable premium. Given the same
return with different risk alternatives, a rational
investor will seek the security offering least risk, or
conversely, the higher the risk, the higher the demanded
return. In the credit market, instruments are all priced
precisely and with uniform standards to reflect risk
aversion. Risk-based capital ratio is a minimum ratio of
estimated total capital to estimated risk-weighted
assets, required by FIRREA (Financial Institution Reform
and Recovery Act). The benchmark for risk-free return is
the three-month treasury bill. The CAPM (capital asset
pricing model) used in modern portfolio theory has the
premise that the return on a security is equal to the
risk-free return plus a risk premium.
The ideal
of a transaction is to be risk-less. A risk-less
transaction guarantees a profit to the trader that
initiates it. An arbitrageur may lock in a profit by
trading on the difference in prices for the same
security or commodity in different markets due to market
inefficiency. For instance, if gold is selling for $450
at NY and $449.86 in London briefly due to market
inefficiency, a trader who acts with electronic speed
may buy a contract in London while simultaneously
selling a contract in NY, yielding a risk-less profit.
These transactions serve a function in eliminating
market inefficiency. Risk-less transaction is also a
concept used in evaluating whether dealer mark-ups and
mark-downs on OTC (over the counter) transactions with
customers are reasonable or excessive. Nasdaq uses the
5% rule, meaning mark-ups (when customer buys) and
mark-downs (when customer sells) should not exceed 5%.
Uncertainty is not measurable, but risk is a
measurable possibility of losing or not gaining value.
The most common risks in finance are inflation risk,
interest rate risk and exchange rate risk. These risks
are interlinked in complex relationships. Other business
risks are inventory risk, liquidity risk, actuarial
risk, regulatory risk, political risk, credit risk, risk
of principal and underwriting, and guarantor risks.
Risk-adjusted discount rate in portfolio theory and
capital budget analysis is the rate necessary to
determine the present value of an uncertain or risky
stream of income. In the so-called New Economy of the
1990s, this discount has been thrown out the window and
replaced by fantastic premiums. It is useful to remember
that interest rate is the cost of money at an annual
rate, interest itself is the cost of using money (debt)
over time. The cost of availability of money is a
standby fee. Money not used is interest-free, regardless
of interest rate.
Interest rate risk exists when
changes in interest rate will adversely affect the value
of an investor's securities portfolio. For example,
holders of long term bonds or utility stocks assume a
significant interest rate risk because the value of
those bonds or utility stocks will fall if interest
rates rise. Interest rate risks can be hedged by buying
interest rate futures or interest rate options
contracts. It is useful to understand that futures and
option contracts are not market prediction, but market
implications that are precisely calculable.
Interest-sensitive stocks are those of firms whose
earnings change when interest rates change, such as
banks, insurance companies, financial companies or
utilities.
Bank participation in derivative
markets has risen sharply in recent years. Average daily
global turnover in OTC derivatives markets increased to
$1.2 trillion in April 2004, a rise of 112% at current
exchange rates and 77% at constant exchange rates as
compared to April 2001. OTC derivatives are traded
outside exchanges between private counterparties. The
notional value of derivative contracts held by all
insured commercial banks in the US increased from $6.8
trillion in 1990 to $11.9 trillion in 1993, an increase
of 75%, to $45.1 trillion at the end of 2001 and $56
trillion at the end of 2002, and continues to grow
dramatically. Nearly 81% of the $56 trillion notional
value of derivatives represents interest rate derivative
contracts at just 5 dealer banks.
The top five
derivatives dealers hold 93% of total notional values.
More than 86% of these dealers' holdings are interest
rate contracts. Therefore, in terms of the derivatives
risk matrix, a vast majority of commercial bank
derivative activity is in interest rate contracts at a
few dealer banks. These dealers conduct derivative
activities as part of their total trading operations,
which makes analyzing derivative risk difficult to
isolate from total trading risk. Furthermore, if a bank
is speculating in derivatives, it occurs within these
trading portfolios and is not reported separately. A
major concern facing policymakers and bank regulators
today is the possibility that the rising use of
derivatives has increased the risk profile of individual
banks and of the banking system as a whole. The global
nature of derivative markets and firms' participation in
them suggests that a disruption in these markets could
have wide-ranging effects that would be transmitted
across national boundaries.
While the number of
banks reporting derivative securities use declined from
587 to 369 during by 2001, the dollar volume of assets
of the banks utilizing derivatives increased from $2.3
trillion to $5 trillion. This represents about 77% of
all commercial bank assets. In 2001, the 25 largest
banks in the US accounted for 99% of bank-held
derivative securities. Bank mergers have since reduced
the number to five. The smaller banks that used
derivative securities utilize them for purposes of
hedging 75% of the time.
On the other hand, the
top 25 banks held most of their derivatives for trading;
at the end of 2001, only 0.6% of the derivatives held by
these giant banks were held as hedges. The remaining 344
banks utilizing derivative securities held close to 60%
of the notional value of derivatives for hedging
purposes; compared with 70% in 1999. The biggest banks
not only participate in the derivatives market as
end-users but also act as dealers by providing OTC
derivatives for non-financial companies. Thirteen
US-based bank holding companies are primary dealer firms
in the derivative market. Derivatives held for trading
purposes are accounted for on the balance sheet at fair
value, with gains and losses reflected on the income
statement.
Risk management techniques that
reduce return volatility can be called hedging, but if
these same techniques are used to increase return
volatility it is generally called speculating.
Derivatives not held for trading are being used for
purposes of hedging. Most derivative contracts are not
traded on organized exchanges, but are traded in the OTC
market between counterparties.
Risk management
is about the creation and preservation of value rather
than the elimination or reduction of risk. Risk-based
capital requirements have been associated with a shift
of assets from loans to securities or into securitized
residential mortgages, and into off-balance-sheet
activities at some banks. Less capital is required for
holding securities rather than loans and for holding
residential mortgage loans rather than commercial or
consumer loans. There is evidence that regulation had a
greater impact on bank capital decisions than did market
discipline.
One of the primary methods banks use
to address risk management concerns is the
implementation of value-at-risk (VaR) models. Banks make
the choice of VaR models based on the response to
regulatory penalties for violations. Banks began to use
VaR models in the late 1980s to measure the risks of
their trading portfolios. Both the Bank of International
Settlement Basel I Accord of 1988 and the 1996 Amendment
discuss the use of VaR models. VaR is a method of
assessing financial market risk by measuring the worst
expected loss over a specified time horizon with a given
level of confidence.
The Basel Committee on
Banking Supervision's paper titled "International
Convergence of Capital Measurement and Capital
Standards: A Revised Framework" deals with the new
capital adequacy framework commonly known as Basel II to
secure international convergence on revisions to
supervisory regulations governing the capital adequacy
of internationally active banks. The committee intended
the framework to be available for implementation by the
end of 2006, but postponed it to 2007. The fundamental
objective of the committee's work to revise the 1988
accord has been to develop a framework that would
further strengthen the soundness and stability of the
international banking system while maintaining
sufficient consistency that capital adequacy regulation
will not be a significant source of competitive
inequality among internationally active banks with the
concept and rationale of the three pillars (minimum
capital requirements, supervisory review, and market
discipline) approach. In developing the revised
framework, the committee has sought to arrive at
significantly more risk-sensitive capital requirements
that are conceptually sound and at the same time pay due
regard to particular features of the present supervisory
and accounting systems in individual member countries.
Fed governor Ben S Bernanke in a speech before
the Institute of International Bankers in Washington DC
on October 4, 2004 highlighted two areas important for
internationally active banks: (1) home-host supervisory
cooperation, and (2) the proposed bifurcated application
of Basel II in the US and the special issues it creates
for cross-border banking. Banks with significant
cross-border operations have concerns about the prospect
of each national supervisor implementing Basel II in
ways inconsistent with the principle of consolidated
supervision. Bernanke observed that Basel II capital
accord is not a treaty, but a consensus that the
authorities in each national jurisdiction will
inevitably apply in their own specific ways, reflecting
their preferred approaches to bank supervision and
regulation.
The large number of banks with
cross-border operations will continue to fall under the
consolidated supervision of their home-country
supervisors. But at the same time, each host-country
supervisor is entrusted by its own government with
ensuring that legal entities operating within its
jurisdiction are operating in a sound manner with
adequate capital. The combination of global banking and
sovereign states has produced "tensions". Three aspects
of Basel II may raise the level of tension experienced
by internationally active banks still further: (1) Basel
II is more complex, (2) it includes requirements for
capital to cover operational risk in addition to credit
risk, and (3) it has all the uncertainties of the new
and the untested.
These issues cannot be fully
avoided in a world order of sovereign states. In
contrast to the treatment for credit risk, Basel II
allows both the consolidated and the individual legal
entities to benefit fully from operational risk
reduction associated with group-wide diversification.
However, host countries entrusted with ensuring the
strength of the legal entities operating in their
jurisdictions will not be inclined to recognize an
allocation of group-wide diversification benefits, given
that capital among legal entities is simply not freely
transferable, especially in times of stress. US
authorities do not see implementation of the Advanced
Internal Ratings Based method for credit risk and the
Advanced Management Approach for operational risk in the
US before 2008.
Theories on financial
intermediation suggest that banks can minimize the cost
of monitoring information by diversifying their assets.
Banks can also use financial derivatives for hedging,
which can be an effective mechanism for controlling
risks. However, there are potential dangers if banks
utilize derivatives for speculative purposes. Banks have
capital "charges" on banks that use derivative
instruments, but these capital costs are independent of
whether these instruments are used for hedging or
speculative purposes. Interest is the cost of debt and
debt is part of the money supply, and in modern finance,
the biggest part. Not all debts are interest-bearing and
some debts carries negative interest either nominally or
de facto due to inflation. The acceptability of the cost
of debt is generally measured against the opportunity
cost of not taking debt.
Interest rate swaps and
currency swaps have seen explosive growth in the last
two decades. Interest swaps are used to reduce risk by
synthetically matching the duration of assets and
liabilities of financial institutions as interest rates
get higher and more volatile. In currency swaps, two
parties sell each other a currency with a commitment to
re-exchange the principal amount at the maturity of the
deal. Originally done to get around exchange control,
currency swaps are now widely used to tap new capital
markets.
The World Bank has been an active
participant in currency swaps with US corporations. An
interest rate swap is an arrangement whereby
counterparties enter into an agreement to exchange
periodic interest payments based on a specified notional
principal amount. Swap options give either the payer or
receiver the right but not the obligation to enter into
an interest rate at a pre-set rate within a specific
period, or the receiver the right to receive fixed
payments. Often, the swaps are further hedged with other
instruments. Debts can be taken in a number of
currencies, other financial instruments and company
shares.
A weak dollar policy is one that forces
or allows, by government policy, the dollar to fall in
value against foreign currencies. That means holders of
dollars and dollar assets will get fewer units of
another currency in exchange for their dollars as on
outcome of government policy. A weak dollar helps US
exports because it enhances the purchasing power of
holders of foreign currencies who may or may not be
foreigners. The conventional factors behind a weak
dollar are: loose US monetary policy, deteriorating
confidence in the US government, trade and/or budget
deficits, relatively low interest rate on
dollar-denominated debt and/or returns on dollar assets,
from both dividends and market capitalization value.
Structured finance exerts fundament impact on
the relationship between interest rate and inflation
rate. The key instrument in structured finance is the
derivative, which is a contract whose value is based on
the performance of an underlying financial asset, index
or other investment. For example, a structured note
issued by a corporate may pay interest to note holders
based on the rise and fall of oil prices. This gives the
investor the opportunity to earn interest and profit
from the change in price of a commodity at the same
time. In this case, it is obvious that market price of a
commodity drives interest rate and not the reverse.
The world of derivatives Other
derivatives are complex debt instruments. It can be a
medium-term note, in which the issuer enters into one or
more swap arrangements to change the cash flows it is
required to make. A simple form utilizing interest rate
swaps might be a three-year floating rate note paying
LIBOR (London Interbank Offer Rate) plus a premium
semi-annually. The issuer arranges a swap transaction
whereby it agrees to pay a fixed semi-annual rate for
three years in exchange for LIBOR. Since the floating
rate payments (cash flows) offset each other, the issuer
has synthetically created a fixed-rate note. The risk of
interest rate fluctuation is passed on to the
counterparties of both ends of the swap. Thus interest
rate risk is exchanged for counterparty risk which
theoretically is less - but not necessarily - risky.
Structured settlements are agreements to pay a
designated party a specific sum in periodic payments
over an extended period, sometimes for a lifetime
without definitive end, instead of a lump sum. The risk
on the uncertain aggregate payout amount is assumed by
the structure. An ordinary option is a derivative whose
value changes in relation to the performance of the
underlying stock. In their 1973 paper, "The Pricing of
Options and Corporate Liabilities", Fischer Black and
Myron Scholes published an option valuation formula that
today is known as the Black-Scholes model. It has become
the standard method of pricing options. Black and
Scholes derived a stochastic partial differential
equation governing the price of an asset on which an
option is based, and then solved it to obtain their
formula for the price of the option.
Black and
Scholes made indispensable contribution to the growth of
the option market by providing a mathematical
calculation for precise pricing of an option, changing
it from mysterious prediction to rational implication. A
more complex example of an option would be a futures
contract, where the option value varies with the value
of the futures contract, which in turn varies with the
value of an underlying commodity or security.
Derivatives on the performance of assets, interest
rates, currency exchange rates and various domestic and
foreign indices are common. A key characteristic of
derivatives is its ability to exploit leverage, which
when used knowledgeably, can enhance returns for
investors and be useful in hedging portfolios. In the
1980s, abuses in program trading became notorious and in
the 1990s, when the protective strategy of portfolio
insurance was distorted to mask systemic risk, leading
to huge losses for hedge funds, mutual funds,
municipalities, corporations, banks, financial
institutions and investment banking houses. These
astronomical losses resulted from unexpected movements
in interest rates, caused by central bank fiats and
exchange rate tumults, adversely affecting the value of
derivatives when unwound.
Bear markets are
prolonged periods of falling prices. Theories aside, a
bear market in stocks is usually brought on by the
anticipation of declining economic activity and
deflation expectation; and a bear market in bonds is
caused by rising interest rates brought on by inflation
expectation. But there is also a market convention that
a bear market in equity pushes a bull market in bonds,
caused by a flight to quality and safety. Thus the
relationships between bond prices and equity prices are
often indeterminate and complex.
A bear spread
is a strategy in the options market designed to take
advantage of a fall in the price of a security or
commodity. A bear spread execution buys a combination of
calls and puts on the same security at different strike
prices in order to profit as the security's price falls.
An alternative execution buys a put of short maturity
and a put of long maturity in order to profit from the
differences between the two puts as prices fall. A bear
trap situation confronts short sellers when a bear
market reverses itself and turns bullish. Anticipating
further decline, the bears continue to sell and then are
forced to buy at higher prices to cover at expiration
date, especially on triple witching Fridays, third
Fridays in March, June, September, and December, in what
the market calls a short squeeze. A bear raid attempts
to manipulate the price of a stock by selling large
numbers of shares shot to pocket the difference between
the initial price and the new, lower price after the
maneuver. Bear raids are illegal under SEC rules which
stipulate that every short sale be executed on an uptick
(the last price higher than the price before it) or a
zero plus tick (the last price was unchanged but higher
than the last preceding different price). There are,
however, enforcement problems of this rule due to the
complexity and speed of transactions and the fact that
foreign markets that trade US shares have different
rules.
Bull spreads can be executed in three
varieties: Vertical spread (simultaneous purchase and
sale of the same class at different strike prices but
with the same expiration date); calendar spread (same
price but different expiration date); diagonal spread
(combination of vertical and calendar spreads). An
investor who believes a stock will rise, even if only
moderately, can buy a 30 call for 1+1/2 and sell a 35
call; both options are "out of the money". The net cost
of the spread, or the difference between the premium and
the based price, is $1. If the stock rises to 35 just
prior to expiration, the 35 call becomes worthless and
the 30 call is worth $5 with an investment of $1. If the
price goes down, the investor loses $1.
Defeasance in corporate finance is a technique
whereby a corporation discharges old, lower-rate debt
without repaying it prior to maturity. The corporation
uses newly purchased securities with a lower face value
but paying higher interest or with a higher market
value. The objective is a cleaner, more debt-free
balance sheet and increased earnings in the amount by
which the face value of the old debt exceeds the cost of
the new securities. The first time defeasance was used
was in 1982 when Exxon bought and put in an irrevocable
trust $312 million of US government securities yielding
14% to provide for the repayment of principal and
interest on $515 million of old debt paying 5.8-6.7% and
maturing in 2009. Exxon removed the defeased debt from
its balance sheet and added $131 million after tax
earnings to that quarter. In that case, high interest
rates actually yielded a profit for a company with
low-rate old debts. Defeasance is now routinely used by
every corporation, confusing the impact of interest
rates on short-term profit.
Collateralized Bond
Obligations (CBO) are investment grade bonds backed by a
pool of junk bonds. CBOs differ from CMOs
(Collateralized Mortgage Obligations) in that CBOs
represent different degrees of credit quality rather
than different maturities. CBO underwriters package a
large and diversified pool of high-risk, high-yield junk
bonds, which is then separated into tiers. A top tier
represents a higher-quality collateral and pays the
lowest interest rate; a middle-tier is backed by riskier
bonds and pays a higher rate; the bottom tier represents
the lowest credit quality and instead of receiving a
fixed interest rate, receives the residual interest
payments - money that is left over after the higher
tiers have been paid.
Then there is the Z tier
that is below all three upper tiers. CBOs, like CMOs,
are substantially over-collateralized and this fact,
plus the diversification of the pool backing them, earns
them investment grade bond ratings. Holders of
third-tier CBOs stand to earn high yields if the default
rate in the collateral pool falls in good times or
falling rates, or lose money when the default rate rises
in bad time or rising rates. CBOs provide a way for big
holders of junk bonds to reduce their portfolio and for
securities firms to tap new sources of buyers in the
junk bond market. CMOs separate their mortgage pools
into different maturity classes called tranches by
applying income (payments and prepayments of principal
and interest). Tranches pay different rates of interest
and can mature in a few months or 20 years. CMOs are
usually backed by government guaranteed or other
top-grade mortgages with AAA ratings. If mortgage rates
drop sharply, causing a flood of refinancing, prepayment
rates will soar and CMO tranches will be repaid before
their expected maturity.
Convertible bonds are
off-balance-sheet obligations that give its holder the
privilege, but not the obligation, to exchange for
securities of the issuing company at some future date
under prescribed conditions, usually when market share
value reaches a certain point. Also, convertible bonds
require the issuer to repay some or all of the
obligation if the share value of the issuer falls below
a specified level. Bond mutual funds are designed to
produce current income for shareholders. Bond funds also
produce capital gain or loss when interest rates
fluctuate. Unlike the bonds they hold, these funds never
mature. Bond swap simultaneously sells one bond and
purchase another, with the motive to swap longer
maturity to produce a profit; or to swap improved yield
for higher risk, or lower yield for higher quality, or
to create tax-deductible loss through the sale while
purchasing a substitute bond to preserve the investment.
It is obvious that derivatives inject elasticity
if not outright distortion in the relationship between
interest rate and inflation rate. And since the notional
value of the derivative market is many times the market
value of the credit and equity markets, this distortion
now dominates markets behavior. This is one reason why
the traditional business cycle has been lengthened. It
is not because of Greenspan's magic touch. But the
business cycle has not disappeared, merely extended at a
cost. The cost is a much more violent and sudden release
of built-up pressures when counterparty risks move
against the system.
The dated archives of
economic literature can yield little light on the
current impact of interest rates on inflation. Anything
written more than 5 years ago must be describing
conditions that bear little resemblance to the current
financial architecture and credit markets and thus
drawing theoretical conclusions that may not be relevant
except in a historical context. The debate on whether
high interest rate is inflationary or deflationary seems
to be a puzzling controversy in economics. Within the
current international financial architecture, interest
rates cannot be fully understood without taking into
account their impact on exchange rates and credit
markets. In a globalized financial market, if the
exchange rate is artificially sustained by high interest
rate, there is little doubt that the impact would be
deflationary on the local economy. This logic is also
supported by empirical data in recent years.
Yet, many astute economists insist that high
interest rate causes inflation, at least in the long
run. Perhaps it is true that high rates can cause
inflation in closed economies, but it is no longer
necessarily true in open economies in a globalized
financial market. Interest rates are the prices for the
use of money over time. These prices do not always track
the purchasing power of money, which is the monetized
expression of the market value of commodities (the
transaction price) at a specific time. The purchasing
power of money fluctuates over time, expressed by the
prices of futures and options which are functions of the
uncertain elasticity between interest rates and
inflation rates.
As the price for the use of
money over time rises, the general effect will be
deflationary if money is viewed as a constant store of
value. Otherwise, money will forfeit its function as a
constant store of value. On the other hand, if money is
viewed as a medium of exchange, the ultimate liquidity
agent, then rising price for its use over time is
inflationary as a cost.
In any economy, money
tends to play both roles, though not equally and not
consistently over time. For market participants,
depending on their positions (borrower or lender) at
specific points of the economic cycle (expanding or
contracting liquidity), they will find different views
of money (exchange medium or value storer) to be to
their financial advantage. Thus borrowers generally
consider high interest rate as leading to cost inflation
(bad), and lenders consider high interest rate as
slowing inflation (good up to a point). Asset deflation
offers good buying opportunities for those who have
money or have access to credit, but bad for those who
hold assets but need money, and the pain is proportional
to asset illiquidity. Since most holders of ready cash
also hold assets, deflation has only limited and
short-term advantage for them. For inflation to be
advantageous, continued expansion of credit is required
to keep asset appreciation ahead of cost inflation.
Defining inflation The problem is
further complicated by the fact that inflation is
defined mostly by mainstream economics only as rising
price of wages and commodities, and not by asset
appreciation. When it costs 10% more to buy the same
share of a company as yesterday, it is considered growth
- good economic news. When wages rise 5% a year, it is
viewed as inflation - bad economic news, despite the
fact that the aggregate purchasing power is increased by
5%. Therein lies the fundamental cause of a bubble
economy - growth and profit are generated by asset
inflation rather than by increased aggregate demand
stimulating aggregate supply. Thus the relationship
of interest rate to inflation is dependent on the
definition of money. But that is not the end of the
story. Under finance capitalism, inflation is not merely
too much money chasing too few goods as under industrial
capitalism. Under financial capitalism, two elements:
Credit availability and credit markets have overshadowed
the traditional goods and equity markets of industrial
capitalism. This makes it necessary to re-examine the
traditional relationship of interest rate and inflation.
In a bull market, the buyer has the advantage
because the buyer has the final upside. In a bear
market, the seller has the advantage because the buyer
is left holding the downside bag. Of course one must
avoid buying at the peak and selling at the bottom. And
such strategies have self-fulfilling effects, as
technical analysts can readily testify. These effects
are magnified in long-run bull or bear markets that are
represented by a rising or falling sine curve. However,
the buyer's advantage in a bull market may be
neutralized by the inflation that usually accompanies
bull markets. Thus a true bull market must yield net
capital gain after inflation and real interest cost, ie
interest cost after inflation. And in a deflationary
bear market, the seller's advantage is reinforced by
deflation for he can repurchase at a later date with
only a fraction of his realized cash from what he sold
previously. Not only would the seller avoid additional
loss of holding the unsold asset in a falling market,
the cash from the sale appreciates in purchasing power
with every passing day.
Thus money plays a
passive role as a medium of exchange and an active role
as a store of value on the movement of prices. The
conventional view that inflation is caused by, or is a
result of (the two are not identical) too much money
chasing too few goods then is not always operative. This
is because the availability of credit and the
operational rules of credit markets can distort the
traditional relationship. Credit markets, which have
expanded way beyond traditional credit intermediated by
the banking system, operate on the theory that money
generally must earn interest, whether it is actually put
to use or not. There are of course abnormal times when
money actually earns negative interest because of
government policy or foreign exchange constraints, as in
Hong Kong in the early 1990s and Japan in 2000.
When idle money earns no interest, credit
reserves dry up, because it creates greater incentive to
put money to work, ie investing it in productive
enterprises. For money to remain idly waiting for better
opportunity, interest rate must equal or exceed
opportunity cost of idle cash. Interest then acts as a
penalty for idle money. When idle money earns interest,
the interest payment comes ultimately from the central
bank, which alone can create more money with no penalty
to itself, though the economy it lords over is not
immune. Since late 1999, the Japanese monetary
authorities have repeatedly reaffirmed their commitment
to maintaining their zero interest rate policy until
deflationary forces are dispelled. The result is a great
deal of idle money in Japanese banks with no
creditworthy borrowers. Japanese savers are foregoing
interest income for increasing purchasing power of their
idle money in an unending deflationary spiral. With
dollar hegemony, the Fed can create dollars by fiat with
immunity to the dollar economy, at the expense of the
non-dollar economies of the world.
Efficiency in
the credit markets pushes money toward the highest use
and willingness to pay the highest interest. Thus when
the central bank tightens money supply, the market will
drive up interest rate and vice versa. Thus interest
rate is a credit market index. When a central bank, like
the Fed, uses interest rate policy to manage the money
supply, it is in essence using a narrow market index to
manipulate the broader market. It is no different than
the Fed fixing the Dow by buying or selling bluechip
shares to influence the broad S&P. Central banking
is incompatible with truly free financial markets.
When prices fall, one reason may be that
consumers do not have money to buy, as in most
recessions with high unemployment. Or it may be the
result of potential consumers withholding their money
for still lower prices as in Japan now, and in some
degree in China in 1998-2000. So deflation is caused by
too many goods trying to attract too little money
entering the market, but not necessarily too little
money in the economy. But if every seller can realize a
cash surplus in a subsequent repurchase in a bear
market, where does all the surplus money go? Obviously
it goes to pay interest on the idle money waiting for a
cheaper price, reducing the central bank's need to issue
more money to carry the interest cost on idle money. The
net effect is a removal of money from the market and
increase the amount of idle money in the economy.
So deflation actually pushes up interest rates
without necessarily altering the aggregate money supply.
The effect is that until prices fall at a slower rate
than the interest rate on idle money, there is no
incentive to buy. Thus deflation-driven rising interest
rate creates more deflationary pressure in a bear
market. High interest rates move more wealth from
borrowers to lenders and from bottom to top in the
wealth pyramid. Moreover, the impact of high interest
rate modifies economic behavior differently in different
income groups and even on different activities within
the same individual. When the prime rate for some banks
reached over 20% in 1980, credit continued to expand
explosively. The opposite happened when the Bank of
Japan reduced interest rate to zero. High rates only
work to slow credit expansion if the rates are ahead of
inflation. And zero rate only works to accelerate credit
expansion if there is no deflation. So raising interest
rate to combat inflation or lowering rates to combat
deflation can be self-defeating under certain market
conditions.
The availability of financial
derivatives further complicates the picture, because
both interest rates and foreign exchange rates can be
hedged, obscuring and distorting the fundamental
relations between interest rates, exchange rates and
inflation. The recurring global financial crises in
recent years were manifestations of this distortion.
The theory of market equilibrium asserts that
market tends to reach "natural" equilibrium as it
approaches efficiency, which is defined as the speed and
ease with which equilibrium is reached. Yet the market
is complex not only because the relationship of market
elements is poorly defined or even undefinable, but also
the very instruments designed to enhance market
efficiency tend to create wide volatility and
instability. Thus a "natural" equilibrium state can, in
fact, be defined as the actual state of the fluctuating
market at any moment in time. With 24-hour trading, the
notion of a milestone moment of equilibrium is
problematic. Further, the very financial instruments
created to enhance market efficiency toward its
"natural" equilibrium state make the equilibrium
elusive. Such instruments are mainly designed to manage
risk generated by both broad market movements and
momentary disequilibrium.
Structured finance
mainly involves unbundling financial risks in global
markets for buyers who will pay the highest price for
specific protection. Because users of these instruments
look for special payoffs through unbundling of risk, the
cost of managing such risk is maximized. This unbundling
renders the notion of market equilibrium inoperative.
The unbundled risks are marketed to those with the
biggest appetite for such risks, in return for
compensatory returns. Thus market equilibrium is not any
more merely a large pool of turbulent transactions with
a level surface. It is in fact a pool of transactions
with many different levels of interconnected surfaces,
each serving highly disaggregated specialty markets.
Equilibrium in this case becomes a highly complex notion
making the impact and prospect of externalities highly
uncertain and unpredictable. This uncertainty and
unpredictability caused the demise of Long Term Capital
Management - the mother of high-flying hedge funds - on
account of failed hedges in a matter of days.
Interest swaps, for example, are not single purpose
transactions for managing interest risks. They can be
structured as hedges against inflation risks, or foreign
exchange risks, or any number of other financial risks
to satisfy needs or provide protection. And the impact
is not limited to the two contracting parties, since
each party usually hedge again with a third
counterparty. That is what makes hedging systemic. A
further irony is that the very objective to insure
against unit volatility risk by covering the market
broadly increases risks of systemic illiquidity. While
each individual contract is structured with immaculate
logic and clarity, the aggregate systemic effect is
totally opaque and incomprehensible. No one really
understands the magnitude of the destructive force that
can result in a chain reaction triggered by the tiniest
rupture. Under such circumstances, it's a puzzle why
China is so keen to join a system that is bent on
self-destruction.
Henry C K Liu is
chairman of the New York-based Liu Investment Group.
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