Over-reliance on dollar is risky

An apocryphal Chinese saying goes, "may you live in interesting times". Whether that is a blessing or not is anybody's guess. However, in the foreign exchange markets that purported munificence is borne out.

The US dollar (unofficially) has become the world's "funding" currency and, surprisingly, this has increased correlated risk across portfolios, thus sewing in them the seeds of the next crisis.

These days, firms sell the dollar or borrow in the low-interest environs of the dollar — and then use these proceeds in order to buy risky assets across the globe. Typically, this was done solely in the foreign exchange markets.

This was the famous "carry-trade". The practitioners of this black art range from sophisticates like George Soros to the innumerable Japanese housewives. Unlike other funding currencies (the yen, for example) the dollar as a funding currency poses peculiar structural issues.

Reliability

In the past the dollar was one of the stores of value for the future. So when one borrowed at low interest-rates in the yen market the number of investment opportunities included dollar-denominated assets.

And given the economic stability and financial reliability of the US markets, a substantial amount of world's investments flew into the US asset market.

Today, however, that advantage of investing and predictability of returns by investing in the dollar-denominated assets (as a source of value and storage of wealth) has shrunk.
So now the question has become: where does all this money go? Who will be the world's storage of value? Understandably, there is no unique answer.

To make matters worse, there is a visceral mismatch between the real and asset economies. In the real economy people remain unemployed, many have settled into a low-income spending equilibrium, selling houses at a premium remains a dream and concerns about educational and medical costs continue.

In the asset economy — equity indices have rallied, risk-aversion seems to be on a decline, bond yields have held low. In a sense, the worst seems to have been averted. Indeed, aided by these macroeconomic moves are the seeds of a serious misperception of global risk.

As the Federal Reserve buys toxic and risky securities from banks on one side (around $1.8 trillion (Dh6.61 trillion) of asset purchase is planned) and keeps interest rates artificially low (to help the banking system return to profitability), the US dollar market acts as an unnatural funding currency.

Real interest rates in an economy ought to reflect the marginal productivity of capital (that is, how much can a unit of capital produce?) after accounting for inflation. And the Fed actions imply that capital productivity in the US is artificially low.

The result of these "unnatural" levels is that an excess amount of global capital is allocated to the non-US markets.

Ostensibly, this intervention by the Fed has reduced the volatility of the markets that involve any kind of Fed intervention.

For example, the asset-backed securities, mortgage backed derivatives, etc, and the economy returns to normality. Predictably, this has produced an illusion of safety and stability and encourages opportunistic behaviour.

Correlation

Any meaningful risk measure of a portfolio is not just about volatility of individual assets that comprise a portfolio. Instead, one needs to account for the correlation involved. However, this is easier said than done.

To account systematically for the correlation between key variables is an onerous task analytically speaking. As a result, banks and hedge funds have rudimentary analytical process in place for risk-measurement where correlation is ignored.

The crises of 2007 revealed a serious shortcoming of our understanding of correlation. Algorithmic trades run by hedge funds (Global Alpha at Goldman Sachs, for example) were seriously exposed as the markets crashed simultaneously.

Today, the dollar-funded trades on various books are skewed to be rewarding if the dollar's slide continues.

But someday soon the dollar slide will end! And one should not be surprised if various markets simultaneously sink — crude oil, emerging markets, foreign exchange and bonds. Till that happens, this efflorescence of risky behaviour will continue.

These tears of joyful profits today contain within them the tears of a busted bubble to come. That, unfortunately, is life during these interesting times.

The columnist works for a major European investment bank in New York City. You can follow his tweets at www.twitter.com/ks1729