More and more analysts are recognising two home truths. The first is that if something appears impossible—e.g., sustained negative interest rates—it’s because it is. The second is the longer the unsustainable continues, the closer is the turning point. As a result, there are suddenly a slew of forecasts calling for a sharp fall in the rupee driven by a reversal (or threatened reversal) of the infinitely loose money policies of the past several years. This, it is rationally argued, would lead to massive deleveraging across the board with the dollar benefiting at the cost of all other assets, with emerging market equities and currencies likely to be the worst hit.
In fact, many of them are even calling for a global equity collapse that would dwarf 2008, when the Dow fell by 50%; I have been fearing this since before the start of this year.
While it is good to have my views vindicated by a wide range of wise men, there are three other home truths that give me pause at this time.
The first is the old saw that the market can stay irrational longer than you can stay solvent. The next—a variation on the theme—is that market irrationality can outfox even the most (supposedly) profound pundits for years; recall that Alan Greenspan, then much more than a supposedly profound pundit, made his “irrational exuberance” comment four years and more than 20% before the equity top in the dot com bubble. And finally, for a market to really turn turtle, naysayers need to be hard to find—with so many of them scurrying out of their research shells suddenly suggests, perhaps, that this a false dawn, or should I say, a false Chicken-Little moment.
So, now that I have very verbosely (and, I hope, eloquently) said I don’t know what is going to happen, let us examine the evidence.
First off, a huge amount—both in absolute and percentage terms—of global “risk-free” assets carry negative interest rates. And, far from pushing growth by compelling companies and people to take more risk—a strange approach—it continues to depress growth, perhaps since spending by retirees and near-retirees is dropping. There are some positive signs—the US employment and wage picture is showing some signs of improvement, although it’s still a patchy picture. Secondly, in countries like India, global negative interest rates are leading to more and more difficulty in holding cash, pressuring the black economy.
Secondly, the long period of very, very cheap money has generated huge leverage in the investment world, a significant part of it used to invest in emerging market debt and equities. Again, unlike in previous deleveraging episodes—how clinical—the currency of choice this time has been largely the dollar. This makes it multiply dangerous. Thus, when—it’s not if—US interest rates start to rise, the giant sucking sound of deleveraging, as investors sell assets to protect their profits, could resemble a cosmic vacuum cleaner.
The third piece of evidence is that historically the three asset prices that move dramatically once they begin have been yen/dollar, dollar/pound and dollar/Libor. Libor has already started moving even though the Fed has only been talking—companies with unhedged interest rate risk on ECB’s need to be very, very careful. Of course, history is only history and it never repeats itself but does so approximately.
And the last nail in the coffin (?) is dollar/rupee volatility. Under Raghuram Rajan’s strong hand and influence, long-term rupee volatility has been below 6% for over a year, which hasn’t happened since 2008, before the last major crisis. Historically (again), whenever rupee volatility, which is at 4.32% today, fell below 5 or 5.5%, the percentage play was to buy dollars, even factoring in the forward premium; while the rupee did not always fall as much as the premiums, it generally fell enough to make a profitable trade.
With a new governor at the helm, it remains to be seen whether he, too, will persist with the policy of keeping rupee volatility low, pending, of course, the global break-out discussed above. It is important to point out that while extended periods of low volatility may (?) make life easier for investors, it creates an unstable situation since companies with short dollar exposures find it difficult to pay a still-high 6% pa hedging cost if the rupee has barely moved by 2% over the previous 12 months. And, as we have all learned many times, large short positions take a bath when things turn. And turn they always do. When, of course, remains the (should we now say) trillion dollar question.
The author is CEO, Mecklai Financial