19/04/2015

Madness has descended upon the financial world, and now even the IMF has issued a warning, having hitherto promoted the liquidity surge known as quantitative easing (QE). In the past week the Fund has worried aloud about the obvious bubbles forming in bond markets, driven to arguably ridiculous levels, just in time for any hike in US interest rates to make the loudest noise in puncturing the balloon.

It’s not as if those markets are genuinely euphoric, however, any more than stock markets that have been led to giddy heights upon the same strobes of stimulus. Bonds are wandering the stratosphere not because national debts are plummeting, to consider supply for instance, but because US, Japanese and now European central banks have sought to suppress yields to the point where demand has become substantially speculative.

Equally, bonds have responded, precisely and ironically, to the failure of the authorities’ underlying strategy thus far to generate self-sustaining economic growth and inflation. It’s difficult to say what success, alternatively, would do, since it would depend on the balance between those variables. Inflation damages bonds, whereas growth, to the extent that it is sufficiently non-inflationary, boosts them.

Additionally, bonds have been the beneficiary of financial regulation in the post-crisis world that requires institutions to favour such instruments because they are still officially regarded as safe, even if the “risk-free” moniker is misleading. That obligation, actually known as repression, has in fact introduced heightened levels of risk, tending lately to the systemic, especially given the current extremes of pricing.

Further to this one-sidedness of the market, US benchmark Treasuries have been propelled also by the outperformance of the American economy compared to other leading blocs. That has translated into the strong dollar, into which funds have flowed via the bond market. Both safe-haven and growth-related attributes are attached to that phenomenon, in a combination hard to resist.

Yet, QE was supposed to drive interest rates down, across the yield curve, according to the operations of the central banks over several years now. It was meant to provoke investors also into so-called risky assets, particularly stocks, as a way of generating a wealth effect, intended to spread from financial markets into the economy. Always dubious in itself, now the policy’s central drawback has belatedly been spotted by its advocates.

Frankly, it almost defies belief that IMF head Christine Lagarde last week should warn of the dangers that this supranational institution and umpteen other “thought-leaders” were instrumental in creating. Very low interest rates were forcing investors to take increasing risks in their hunt for a worthwhile return, she observed. No kidding. What was once a declared objective is now sagely identified as an unwelcome development.

In the midst of the kerfuffle gradually brewing over likely market fallout — of maybe colossal magnitude, and one that undoubtedly will migrate worldwide, across stocks too — we might wonder how the Gulf’s fixed-income offering is faring.

Having previously recognised that the region’s dollar link adds a positive element, while depressed oil prices have a negative connotation, we might also suppose that a degree of price softening in bonds would be associated with the weakening of the GCC exporters’ financial surplus, while a countervailing, imitative effect still follows from the bullishness of overseas trends.

With emerging markets edgy generally, a certain tentativeness would be unsurprising at present, particularly given the remarkable run already seen.

The suspicion of a sideways tendency is borne out by Bank Audi’s description of “mixed price movements”. The reasons are mixed too. Some bonds have tracked declines in Treasuries after US jobless claims data and Greece’s loan repayment to the IMF, the bank reported. In contrast, some accounts, both local and offshore, were tempted into longer-dated paper upon curve steepening (i.e. higher yields).

In fact, a research note from Emirates NBD’s analyst Anita Yadav tells us, the regional market has remained buoyant, so much so that, even on purely a relative basis, it’s time to ask whether it is overpriced against emerging market (EM) peers.

The answer, apparently, is no, whether studied against global and US bonds on an investment-grade or high-yield basis, or in light of their own trading history, or in terms of yield differentials against EM counterparts. “All three assessments indicate that GCC bonds are not expensive compared to the rest of the [credit] universe, and in fact spreads [against benchmarks] may have the potential to tighten further,” the memo says.

In the world of investment analysis, “expensive” has the meaning “excessively priced”, as opposed merely to “costly”. In the world economy, though, it could easily be that sheer cost will soon reach its limits, particularly if the growing doubts about stimulus strategies reach critical mass.

In that case, it would not be unreasonable to anticipate a correspondingly sheer market response, in which the Gulf region is liable to swept along as well.

Andrew Shouler - Gulf News