Riesgo Pais
By James J Puplava CFP, March 31, 2005
Traders on bond desks have a special name for risk. Market pros use
the term "country risk" to describe and quantify the added cost or
yield a foreign country has to pay over risk-free Treasuries. In
Spanish, it is called riesgo pa�s. Essentially we're talking
about bond spreads or the premium offered on riskier bonds. In times
of crisis, it becomes front page news. During the Argentine debt
crisis of 2001 riesgo pa�s became a regularly reported statistic in
the nightly news. Everyone followed it, from the politicians to the
man on the street. The lower the number, the better off the country.
A high number was indicative of a crisis.
As a result of record low interest rates in the U.S., the "carry trade", and the global search for yields, riesgo pa�s has fallen dramatically over the last two years. Investor appetite for riskier assets drove up prices and shrank yields globally. Toward the end of last year spreads on all types of debt: corporate, sovereign, investment grade and high-yield narrowed and closed below their historical lows. Junk bonds and emerging market debt have been one of the best performing asset classes the past two years. Last year junk bonds and emerging market debt beat the returns earned on equities in the U.S. As shown in the two graphs below, investors in junk bond funds and emerging market debt earned double-digit returns as opposed to single-digit returns in equities.
With the Fed keeping interest rates artificially low in the U.S., the global search for yields naturally gravitated to riskier asset classes. It is the reason why junk bonds and emerging market debt outperformed equities.
A
drop in historical long-term interest rates occurring at a time the
Fed was raising short-term interest ratest gave way to what Fed
Chairman Greenspan called a "conundrum." Instead of rising
long-term rates, interest rates remained range bound. By the end of
February 10-year U.S. Treasury yields remained close to 30 basis
points below where they were when the Fed began raising interest
rates. What was perplexing for bond investors last year is that long
rates headed down instead of up as the markets had been
anticipating. In its recent quarterly review the Bank of
International Settlements attributed the decline to three factors - a
reduction in the inflation premium, risk premium, and a drop in
forward rates. The decline in forward rates is where the real
conundrum lies. It could be due to lower inflation and risk
expectations or more likely it represents a temporary imbalance in
the supply and demand for government securities. Strong demand from
pension and insurance companies"large buyers of long-dated
bonds - have put pressure on prices because of demand.
Source: BIS
Nonetheless, last year long-term yields fell across the board in all risk categories of bonds. As shown in the charts below, yields fell everywhere. In addition to a drop in yields, implied volatilities also fell. The "carry trade" also exerted an influence on yields. With the Fed taking a measured approach to raising interest rates, it still remained profitable to borrow short-term and invest in long-term bonds. The move further on the risk scale by fund managers and investors was due to the narrow range on high quality bonds. In order to get the most out of the "carry trade," investors in search of higher returns moved more aggressively into spread products such as junk and emerging market debt. Investors were simply ignoring risk. With the Fed taking a measured approach to raising interest rates, the "green light" had been given to risk taking. This was the moral hazard at work. High levels of debt issuance went unnoticed by the markets. High levels of demand absorbed the increasing supply.
Source: BIS
By the end of the year A-rated corporate bonds were yielding only 64 basis points over comparable Treasuries. Spreads on emerging market debt had narrowed to only 335 basis points. On US issued junk bonds the spreads had fallen to 275 basis points. The yields offered on higher-risk bonds became a magnet for hot money. The result is that yields kept falling along with implied volatilities.
Source: BIS
That was last year. This year the markets have changed. With inflation on the rise the Fed may have little choice but to get more aggressive in their rate hikes. There is a growing consensus among Fed governors that something has to change. The CRB index surged to a 24-year high on March 16th. The index is up 12 percent this year. Oil prices are up 33 percent since the beginning of the year and gasoline prices have risen to over $3 a gallon in certain parts of southern California. The dollar has fallen over 2 percent since the last Fed meeting despite massive foreign buying in January and February.
Four factors are at work driving up inflationary risks: an accommodative Fed, rising raw material costs, dwindling economic slack, and declining productivity. Moreover, the recent Fed Beige Book notes that companies across the country are having no problem in passing along price increases to customers. Airline fares are going up, coffee prices are up 12 percent, car rebates are dropping, service fees from doctors and dentists to satellite radio are up high single digits and in some cases double-digits.
It becoming apparent to the financial markets that pipeline inflation is on the rise. Price pressures are starting to show up in the rate investors are seeking as protection against higher inflation. The markets are waking up to the fact that the credit markets are becoming less benign. The riesgo pa�s is rising rather than falling, which signals trouble lies ahead for the bond markets. Yields across the board are rising once again from Poland to Pakistan, from Turkey and Russia to Argentina and Brazil. Emerging market spreads are up 6 basis points to 369. That's up from year-end when they stood at 335. Bond investors and politicians in Latin America are watching the U.S. bond markets closely and paying attention to every nuance emanating from the Fed. Rising interest rates in the U.S. means rising rates for most of Latin America. Interest rates are up in Argentina, Brazil, Uruguay, Peru, and Mexico. Junk bond yields are also rising especially after last week's bombshell by GM.
The credit cycle appears to have peaked. Strong corporate earnings, which have helped to bolster corporate bond prices, are on the decline. Corporate profits for S&P 500 companies, which were up 19.7 percent last year, are expected to slow down to 10% or less this year. Even then that figure may be optimistic. With revenue growth starting to slow, companies are looking for other ways to maintain earnings growth. As a result they are re-leveraging their balance sheet with options ranging from stock buybacks and upping dividend payouts to mergers and acquisitions. Syndicated financing for leverage buyouts rose to an all-time high of $49 billion in the fourth quarter of last year. This year is following a similar trend with two back-to-back months of $100 billion plus in combined mergers. In addition the number of bond upgrades by Moody's fell from 1.1 percent in Q3 to 0.7 percent in Q4. All of this suggests that the credit cycle in the US may have already peaked. Mortgage activity and refinancings are up in southern California according to mortgage bankers. However, this reflects a rush by homeowners to lock in rates before they begin to climb. It is becoming sort of a last chance to cash in on lower rates and homeowners are taking advantage of it. The word is out that 5% mortgages are a thing of the past. Soon 6% mortgages may also be on their way out. Say hello to 7% mortgages.
The word is that the "measured" approach to raising interest rates may be on its way out. The surge in the price of oil, the rise in commodity prices, and the climb in import prices are heightening inflation concerns in the financial community. Fed governors have been chiming in with remarks suggesting that the good times are over. Alan Greenspan in his recent congressional hearings remarked "We're not going to have the same statement in perpetuity. At some point it is going to change." Atlantic Fed Bank President Jack Guynn recently said "You can imagine not so far down the road where some things in the statement aren't going to be appropriate."
Former Fed governors are also chiming in with clues. Laurence H. Meyer said recently "Everybody appreciates that it’s going to need to be removed at sometime soon. I would think it’s not far off"possibly at the May or June meeting." Wall Street bond firms agree that "soon" may mean June. According to a poll of 22 firms that deal directly in government debt, 13 now believe that the word "measured" will be eliminated at the June FOMC meeting. Even Alan Greenspan has refrained from using "measured" in four appearances before Congress.
It is becoming apparent that change is in the wind at the Fed. The benign financial environment is going to get rougher. Look for the Fed to get more aggressive in its tone and to start raising interest rates more aggressively until something breaks. It looks like that break may first start to appear in the stock market where a broadening top is playing out in the major indices such as the Dow and the S&P 500. The Nasdaq has already started to break. Tech fundamentals look bleak with the book-to-bill ratio recently falling below 0.80 and tech insiders are selling their shares in record numbers. If the guys who pilot the company are reaching for parachutes, what about the average investor, who remains clueless?
The Fed may have other problems besides inflation. A growing chorus of central banks from South Korea, Japan, China, India, Russia, and Malaysia to OPEC are reducing their exposure to dollar-denominated assets. It is one reason the dollar has fallen over the last three years. It isn't because of selling. It is because of less buying. If central banks started to seriously sell, we would be in a full-blown financial crisis. Even with the dollar's decline, America's trade and current account deficit keep worsening. The current account deficit was tracking at an annual rate of 6.3% in the fourth quarter of last year. This year it is expected to go even higher. It is currently tracking at a $750 billion dollar rate. This translates to a need to borrow $2.9 billion a day. That figure is up by almost 40% in three years. This year the current account deficit is expected to rise to 6.5% of GDP, in 2006 it will rise to 7% of GDP and by 2008 it will climb to 8% of GDP. By then our net foreign debt will increase to 50% of GDP equaling 500% of all export revenue. Debt of this magnitude has a new name given to it by Lawrence Summers, who calls it the "balance of financial terror,� a system whose stability hinges on the willingness of Asian central banks to both hold enormous amounts of US Treasuries and to continuously add to their enormous stock of Treasury holdings just to keep the present Bretton Woods Two system from imploding. [1]
That is unlikely to continue. Several central banks as noted above have already hinted at their displeasure with Washington's fiscal policies. These central banks don't have to sell their bonds for interest rates to rise here in the US. They simply have to absent themselves from government bond auctions or to convert more of their dollar surpluses into other currencies. The result would be a fall in the dollar and a rise in long-term interest rates. We already know that oil prices have headed higher since January. A drop in oil prices at the beginning of the year had been one of the mitigating factors in keeping the January trade deficit lower. Things have changed since then. Oil prices have climbed from the low 40's to the upper 50's. So February and March's trade deficit should be a lot higher. Americans are still buying foreign cars, foreign electronics, foreign clothing and everything else that is foreign that stock most local store shelves. The trade and current account deficit are getting worse not better which indicates a financial crisis is on the horizon. This may be 1987 all over again. This time it could be worse and the economic consequences could become staginflationary.
The average investor should be on the alert that the financial landscape is changing. It is time to look for a financial parachute. The riesgo pa�s is rising globally, including the US. It may be the first sign of the financial unraveling that is on its way. A rise in riesgo pa�s is just the first clue a storm is on its way. A rise in volatilities is next as is a broadening stock market top. It is time to start buying financial insurance. Start adding to gold positions, while the commercials are shorting the gold and silver markets. They are providing you with another entry point. Take heed for you have been forewarned.
Today's Markets
Major stock indexes headed sharply lower today as higher oil prices and heightened inflation fears weighed in on the markets. Investors are a bit nervous ahead of tomorrow's meeting of the FOMC. The Fed is widely expected to raise interest rates another quarter of a point raising the federal funds rate to 2.75%. It is also becoming obvious that the Fed won't stop there more interest rates are on the way at the May and June FOMC meetings.
The Dow Industrials lost 64.28 points to close at 10,565.39. The S&P 500 dropped 5.87 points to close at 1,183.78. The Nasdaq rebounded from its lows earlier in the day to close down by 0.28 a point at 2,007.51.
Crude oil for April delivery fell $0.10 to $56.62 a barrel. Gold prices fell sharply by $8.30 to close at $431.40 an ounce. Commercial short positions in gold have increased significantly. The dollar was up by 1.1% against the euro at $1.3168. It was up by 0.3 % against the yen to 105.10. The 10-year Treasury note was down 4/32 with the yield edging up to 4.52 %.
Chart courtesy: Bloomberg, Bank for International Settlements, Stockcharts.com
[1] The US as a Net Debtor: The Sustainability of the US External Imbalances, By Nouriel Roubini
James Puplava
© 2005 James Puplava
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James J. Puplava CFP
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