Market Watch: Investors should not be betting on lasting liquidity

The end of time is a favourite idea in most religious texts — with fire, brimstone and eternal cycles of rebirth that await the recalcitrant. On Wall Street, something less dangerous, but equally uncertain, awaits those who live dangerously. The only question now that keeps money-managers up at night is when will this "loose money" policy end. China has recently tightened the yield on a three month bill from 1.328 per cent to 1.3684 per cent. The Fed fund futures market implies an increase in the targeted rate up to 0.9 per cent by December this year from the present target range of 0 per cent to 0.25 per cent. Canadian markets predict a rise in rates by 1 per cent before the end of year. In essence, "free money" might be less free!

So, conventional risks from portfolios as defined by leverage, unhedged positions and exposure to second-order risk factors (like convexity of a portfolio) and so on, all continue to exist. But, alongside is the interest-rate-regime risk that has emerged. So, like a gear change in the biggest automobile on the highway, a change in pace can lead to various side-effects on other travellers. As instinct would tell us, a few fender-benders are pretty likely.

Over the past two years the government-sponsored financial agencies (from the US Treasury onwards) have continually increased money supply in the system. From direct intervention to less direct means by orchestrating a series of roundabout purchases of toxic assets — all in an effort to provide a floor to various price levels and prop up anaemic balance sheets.

The result of this has been the rise of the carry-trade in the foreign exchange market. Typically a speculator borrows from a low interest rate denominated market and invests/loans it in a higher interest rate — paying currency's debt. In stable environments the expected appreciation or depreciation of a currency-pair (US dollars against yen, for example) ensures that no riskless profit can be made. This condition is called "the interest rate parity" — that is, the equivalence of net returns across the globe. However, these are hardly stable markets. Thanks to the sustained governmental intervention and lower rates — traders have entered into massive positions of carry trade — where on a daily basis by virtue of just holding the position, they earn the interest rate differential.

However, should the policy alter and rates move up as, or more than, implied, this would result in a global stampede to head for the other direction, to unwind their existing positions. The impact of the negative carry trade has led economics expert Professor Nouriel Roubini to caution and warn against the "mother of all carry trades" that is in place. However, in recent times he has begun to point out that while the party is on, why not have some fun? This school of thought advocates that the foreign exchange market is driven by momentum trading — that is, trading based on second or third order beliefs about other traders. Belief that others believe the rates will not increase. So, the argument goes — in absence of overt inflationary pressures — why not earn a little daily "carry" (earnings from a positive carry trade)?

Equity rise

In contrast, Bill Gross — the "bond king" of Pimco in California — has argued that much of the US and global equity rise since March can be traced to loosened taps of the governmental exchequer. Entering into trades today informed by expectations based on policy information data that is two to three months old can lead to inappropriately allocated strategies. Further, as financial expert Yves Smith notes, even if data doesn't validate, inflationary fears can easily show up in the commodity markets. For as inflationary prospects increase, firms end up buying commodities as a hedge. So, while their monthly returns from fixed income declines in real value, commodities arguably keep pace with that decline. Thus, any commodity price rise will leak into the real economy and so the central banking authorities might raise rates faster than anticipated today. The net result will be the bursting of this speculative run we have had, courtesy of the broken interest parity.

So, while we continue to debate, ridicule and question the insights and relevance of overextended governments the undeniable fact remains that what the government policies bestow, the government can take away just as easily.

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