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Thursday March 10, 2005 - 14:34:31 GMT

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The dangers of yield investing

The economic fundamentals justify some strength for currencies such as the Australian dollar and greater confidence in emerging markets. Nevertheless, the overall behaviour of asset markets and prices suggests that excess global liquidity has encouraged a dangerous level of market interest in high-yield and emerging-market assets, especially as speculative interest in commodities has reinforced the trend. Markets are probably not discounting sufficient financial risk at current levels. The recent price trends also suggest that the global central bank monetary policies are not tight enough and, if this is the case, inflation fears will push long-term yields significantly higher as well as encouraging a further Fed tightening. As interest rates rise, there will be a high risk of a very sharp decline in commodity and high-yield currencies which could spread to emerging markets. Any evidence of financial stresses would risk a very sharp market adjustment.

Speculative interest at record levels

The market is still showing very strong interest in high-yield investments and there are dangerous signs that a speculative bubble is forming.

The Australian dollar strengthened to near 0.80 against the US currency before a correction and the New Zealand dollar hit a 23-year high above the 0.74 level against the US currency this week. Although general US currency vulnerability suggests that some US dollar depreciation is justified, there has been evidence of extreme speculative activity.

The number of long IMM Australian dollar positions, for example, has increased to a record high at over 50,000 contracts. Investors have also been willing to overlook substantial current account deficits in Australia and New Zealand over the past few months at the same time as fretting over the US current account deficit.

Evidence of a bubble?

There are other signs of a speculative bubble developing. Over the past few weeks, the swap spreads over US Treasuries has fallen to multi-year lows and yield spreads on emerging market bonds has also dipped to the lowest levels since 1995. The markets have taken comfort from the fact that there have been no major financial shocks in emerging markets. There have also been improvements in sovereign ratings with credit upgrades outpacing downgrades by close to 3-1 over the past two years while growth rates have improved. Nevertheless, the yields have narrowed to an extent that is difficult to justify, particularly as the improvement may prove to be cyclical rather than structural.

There are, for example, also a record number of long speculative Mexican peso positions which has strengthened the Mexican peso to beyond 11.00 against the US currency. Overall indicators of risk aversion have also fallen to very low levels.

Gains built on weak foundations

The strength of currencies such as the Australian and New Zealand dollars together with the South African rand have been linked with the strength of commodity prices. There have certainly been strong gains in commodity prices with the Reuters CRB index strengthening to a 24-year high this week. The difficulty is that investors are using the strength of commodity prices to justify buying commodity-linked currencies such as the Australian dollar. There are supply shortages in commodities such as copper which justify firm prices and Chinese demand is still strong, but the price increases still appear to have gone further than fundamentals would justify.

There is also a high risk that commodity price gains are, in turn, built upon speculation rather than fundamentals. If this is the situation, then the case for buying commodity currencies is also flawed and based upon a false premise. There will be a high risk of reinforcing declines in both asset categories on a cutting of speculative positions which could also lead to capitulation selling.

Liquidity needs to tighten.

There will be a strong suspicion that the low and stable level of US Treasury yields over the past few months has encouraged a flow of funds into alternative and higher-yielding assets to boost returns. The Fedís determination to supply sufficient liquidity to the global markets will have also contributed to a build up in speculative activity and increased risk taking.

If US yields rise, there will be less willingness to maintain these investments. Rising short-term US interest rates will also make it less attractive to borrow dollars and invest in high-yield assets. US bond yields have risen significantly this week and there will be the risk of a sharp market adjustment if inflation fears increase further. The US Federal Reserve also needs to slow global dollar supply growth.

The overall behaviour of asset prices also suggests that central bank monetary policies have not been tight enough over the past 2 years. If wider inflationary pressure starts to build, there will be pressure for a sharper pace of monetary tightening. A sharp rise in yields would increase the risk of casualties in the financial sector which, in turn, would sharply increase market risk aversion and pressure to cut high-yield positions.


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