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Economist Insights 2013 10 14

Economist Insights 2013 10 14

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Published by buyanalystlondon
Economist Insights 2013 10 14
Economist Insights 2013 10 14

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Published by: buyanalystlondon on Oct 14, 2013
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Economist Insights
The rough with the smooth
14 October 2013Asset managementThe risk to financial stability that has been on the market’smind for the last week or so has understandably been therisk of the US technically defaulting on its debt. Such anevent would be a classic tail risk: low probability but very highimpact. Last week the International Monetary Fund (IMF)reminded everyone that there are still plenty of other risksthat are less dramatic but much more likely to occur. In itssemi-annual Global Financial Stability Report the IMF set outa few of its concerns, many of which are unique to this cycle.The first of the IMF’s concerns is that when yields rise, it couldbe far more volatile and disorderly than hoped. The last fewyears of unprecedented low rates and unconventional policyhas created challenges. The worry is not so much that therecould be unexpected moves in yields as they rise – this wouldhardly be unusual – but rather that policy over the last fewyears has made such unexpected moves more dangerous.Low rates, as always, encourage a search for yield amongstinvestors. Aside from shifting into higher yielding corporatedebt, investors also extend the maturity of their debtpurchases by lending for longer terms. Normally theterm premium of extending for a few years should giveinvestors the extra term premium they require. However,the unorthodox policies of quantitative easing (QE) andforward guidance explicitly aim to flatten the yield curve: i.e.,make longer term borrowing cheaper by reducing the termpremium. To get the same term premium pick up, investorsneed to extend their maturity even further. Issuers of debthave taken advantage of lower long-term yields by issuinglonger-dated securities, locking in cheap borrowing. The netresult has been to increase the average maturity of bondportfolios around the world (see chart 1). The longer thematurity of the bond you buy, the more sensitive its price willbe to higher yields: what is known as duration risk. If yieldsunexpectedly rise, investors will suffer more pain and may bemore likely to panic, exacerbating the volatility.The IMF is also worried about liquidity in the market. Investmentbanks have been forced by regulation to de-risk following thefinancial crisis, which may well be very sensible but as with allpolicies there are unintended consequences. Investment banksand other dealers normally carry inventories of bonds and othersecurities on their books, much in the same way that a shopcarries an inventory of the goods that it sells. De-risking meansthat dealers are unwilling to carry large inventories of riskiernon-government bonds (see chart 1). If investors do panic andtry to sell a lot of these bonds, dealers will be unable to absorbthem even if they want to. Prices will fall further which couldmake the panic worse. All this spells greater volatility.The second concern is emerging markets. The search foryield has also encouraged investors to look for better returnsin emerging markets (EM). After an initial flight to quality inthe wake of the financial crisis, investors not only returnedto the pre-crisis trend of allocating more to EM, but actuallyincreased it. This encouraged credit growth and imbalances
Joshua McCallum
Senior Fixed Income EconomistUBS Global Asset Management joshua.mccallum@ubs.com
Gianluca Moretti
Fixed Income EconomistUBS Global Asset Managementgianluca.moretti@ubs.com
Chart 1. Longer with less
Duration of global bond portfolio benchmarks (years) and ratio of dealerinventories to the stock of outstanding US non-government bonds (%)
Bond portfolio benchmark duration (lhs)
   D   u   r   a   t   i   o   n   i   n   y   e   a   r   s    %
US nongovernment bond dealer inventory to stock ratio (rhs)
Source: IMF Global Financial Stability Report October 2013
The IMF’s Global Financial Stability Report remindedeveryone last week that there are a number of risks lessdramatic than a US default but more likely to occur.The IMF set out its concerns about a disorderly rise inyields, volatility in emerging market exchange rates, andovershooting of inflation expectations in Japan. These risksdo not take into account policy reaction to counter theeffects, which central banks would be expected to take.But they illustrate that the return to smoother growthcould well be a rougher ride than you might think.

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