16 March 2007

A sea-change in risk perception

A sea-change in risk perception
By Jephraim P Gundzik

Overly loose monetary policy in the US and Japan has masked rising global investment risk. This tidal wave of cheap dollars and yen encouraged investors to ignore age-old risks associated with soaring credit growth.

Plunging stock markets around the world and dollar depreciation indicate that risk perceptions are changing dramatically. This change in risk perception will produce a prolonged and sharp correction in all of the world's stock markets. Growing risk aversion will push US Treasury yields lower, triggering dollar devaluation and soaring precious-metals prices in the months ahead.

Blame the Fed and the BOJ

In an attempt to deflect imported deflation from Japan, the US Federal Reserve under Alan Greenspan began to loosen monetary policy in early 2001. After the terrorist attacks on New York City and the Pentagon in September 2001, the Greenspan Fed pushed interest rates aggressively lower to support the US economy and financial system. Though the economy began to recover in 2002, the Fed maintained its aggressive easing through 2004, pushing US interest rates to a 50-year low.

The Fed reversed course in late 2004, but the very slow pace of monetary-policy tightening did little to weaken thriving mortgage-credit growth, which continued to bound higher in 2005. The combination of super-loose monetary policy and very gradual monetary-policy tightening encouraged mortgage lenders in the US greatly to loosen credit standards, triggering unprecedented growth in US real-estate values and home construction.

The booming housing market accelerated US economic growth, further obscuring investment risk associated with very rapid credit growth and sharply deteriorating credit standards.

The Bank of Japan (BOJ) followed the Fed's example throughout the early 2000s, leaving nominal interest rates at 0%. Monetary policy in Japan was further loosened after the BOJ implemented its quantitative easing policy, which flooded the financial system with cash in the hope of reviving domestic credit growth and private demand. Rapidly changing demographics in Japan muted the impact of the BOJ's free-money policy. This forced the BOJ to prolong this policy, which remains largely in place.

Though the BOJ had trouble boosting private demand at home, its free-money policy began to flow through the financial system, which became an intermediary for external yen borrowing. This external borrowing, more commonly known as the yen carry trade, lavished trillions of yen on foreign banks, brokers, insurance companies and investors who subsequently invested in much higher-yielding assets, especially in emerging-market countries.

The limitless supply of ultra-cheap yen from the BOJ greatly obscured investment risk not only in Japan but wherever the yen carry trade was used by investors to boost returns. Because the yen carry trade was employed in stock, bond and real-estate markets around the world, the BOJ in effect muted global investment risk, pushing asset values to massively overvalued levels relative to risk.

Risk exists after all

Though monetary policy in the US and Japan remains extremely loose, the sudden downdraft in global equity markets and dollar depreciation, which began early this month, indicate that risk perceptions have changed dramatically. This sudden shift was driven by unexpected weakness in the US economy - the product of the collapsing housing market, soaring real-estate foreclosures, and their very negative impact on the US financial system.

Investors around the world ignored excruciatingly obvious indications, which first appeared in early 2006, that the US housing market was rapidly weakening. Investors also failed to understand the negative implications this weakness held for global economic growth and asset values. While the Fed and the BOJ are to blame for obscuring investment risk, the perpetuation of this masquerade has been greatly abetted by the world's largest investment banks and brokerages.

These institutions, with their exceedingly optimistic global economic outlooks, also encouraged investors to ignore investment risk associated with super-fast credit growth. The time has come to pay the piper. Banks, brokerages and investors will pay a huge price over the next several months for ignoring rising investment risk over the past several years. Unlike the mid-2006 mild correction in global asset values and the dollar, the current correction promises to be exceedingly brutal.

The 2006 mini-correction was driven by fear that monetary policy in the US and Japan would tighten significantly. The Fed and the BOJ quickly allayed these fears by keeping monetary policy overly loose. This led to a rebound in asset values and dollar appreciation against the yen as investors redoubled their yen-carry-trade positions.

In contrast, the current correction is being driven by the closing gap between US economic reality and perceptions spun by banks and brokers promising a "Goldilocks" recovery. As the reality of rapidly slowing US economic growth and spreading problems in the financial system overtakes investors, the overvalued US equity market will continue its downward trek, falling another 20% at least. To be sure, the gathering US economic recession will force the Fed to loosen monetary policy further. However, this will do little to arrest the decline of the economy or the stock market.

Though interest rates will fall in the US, this will not immediately stimulate a resurgence in the housing market. Mortgage lenders and banks saddled with growing non-performing loan portfolios will continue to tighten credit standards, leaving many potential borrowers in the cold. At the same time, surging foreclosures will add to the housing supply, forcing home prices much lower. This loss of home equity combined with a credit drought will undercut private demand in the US, prompting a rise in unemployment and further weakness in private demand.

A 20% correction in US stocks will push stock markets around the world lower. However, emerging-market equity and bond prices are likely to plunge much more deeply. The yen carry trade has pushed hundreds of billions of dollars into emerging-market assets over the past two years, though investment risk in many countries has increased exponentially. Economic recession and falling interest rates in the US could prove to be the dollar's death knell, forcing sustained unwinding of the yen carry trade.

Dollar weakness will greatly benefit precious metals, especially gold, in 2007. Falling US interest rates will also benefit precious metals, particularly if rising commodity prices continue to push global inflation higher. The pendulum has begun to swing away from risk predilection toward risk aversion. Fasten your seatbelts, because this swing is gaining momentum.

Jephraim P Gundzik is president of Condor Advisers. Condor Advisers provides investment risk analysis to individuals and institutions worldwide. Visit www.condoradvisers.com for more information.

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