The Canary Correction - Part 1
In fact, none of the five major asset classes (equities, commodities, currencies, bonds and real estate) were immune. In this two-part article, we will examine the emerging financial troubles, look back for times when similar challenges threatened global markets and explore what this development and financial indicators may be trying to tell us about the future.
Of Canaries and the Carry Trade
One of the greatest attributes of all successful traders is their ability to step back and take a long hard look when things go wrong. Repeating mistakes in this business is a good way to go broke in a hurry. With the “canary correction” in May and June, traders around the world were forced to re-evaluate as losses mounted. What caused the meltdown and could it have been anticipated? More important, what does it mean for markets going forward?
To begin to plumb that question, we need to step back in time. As global economies came out of the 2001 recession, money managers resumed their search for new investment opportunities. One that attracted attention was to become known as the carry trade, and it relied on the international interest rate differences. Borrowing funds from banks in nations where rates were low, such as Japan, and lending in other economies where high rates existed, such as Iceland and New Zealand, global bond traders could pocket a handsome profit. In Japan the bonds became known as uridashi or “bargain sale.”
The only real downside was currency risk. As long as the Japanese yen didn’t soar or currencies in the recipient nations didn’t plummet, profits accumulated. As more investors piled into the game, target countries experienced unprecedented influxes of cash, heating up economies and propelling stocks, real estate and wages higher. In two short months, Iceland’s inflation rate rose from 4.5 percent in March to 7.6 percent in May 2006, and the nation’s current account deficit hit an incredible 16% of GDP. Inflows of foreign capital had made the economy unstable. An economic canary had started to sing.
Back in late February, however, the carry trade game had already begun to unravel. Realizing the risk of an “unsustainable” 16% current account deficit, Fitch Ratings downgraded Iceland’s debt. Traders dropped the krona like a hot potato, causing the currency to fall 10% in less than two days.
On June 6, the situation took a turn for the worse. First came of the resignation of Iceland’s Prime Minister. Then on the same day a credit downgrade was announced by another credit rating agency – this time it was Standard and Poor’s – from stable to negative, dropping the Icelandic krona a further 3% the following day. An analyst for S&P commented that the current situation increases the chances for a hard landing as the boom that started two years ago and resulting economic imbalances begin to unwind. Not the kind of situation carry trade bondholders wanted to see.
In New Zealand, inflation had also become a problem and the overnight interest rate had risen to 7.25 percent, driving mortgage rates up to more than 9 percent. In spite of this, the New Zealand dollar had dropped more than 15% in a year. This put carry trade bondholders invested down under seriously underwater. To make matters worse, the New Zealand government announced that GDP growth had turned negative for Q4-2005. Like piling concrete bricks into a sinking boat, poor economic performance is the last thing a struggling currency needs. This left no room for increasing interest rates, the standard central bank remedy for rising inflation and a falling currency. Now the canary was singing in Auckland.
As an example of how popular the carry trade became, Japanese investors purchased 6.63 trillion yen ($64.2 billion) in foreign bonds during the first two months of 2005. But little more than a year later by May and June 2006, this had dropped by two-thirds to 2.60 trillion yen ($20 billion). The carry trade was rapidly unwinding and with it investment flows into high-yield economies, many of which were emerging markets.
And such excesses were not limited to bond markets. According to the Economist, foreigners invested $61.4 billion in emerging-market equities plus an additional $237.5 billion in direct investments in 2005. By the end of the year the market capitalization of all exchanges in emerging economies was $4.4 trillion, up from $1.7 trillion in 2002. Asian markets had tripled in size.
Such flows of capital have a tendency to destabilize smaller markets and economies. With such rapid growth in funds pouring into small economies and emerging markets, it was only a matter of time before a serious stock market correction came.
Iceland and New Zealand were major recipients of the carry trade, but they were just two of a number of economic canaries singing an alarm that something was amiss. Together with a major correction in emerging stock markets worldwide, Turkey, Hungary and Mexico were also having problems.
But there is another ticking time bomb that, if it were to blow, would be far more devastating than a melt of bond and stock markets combined – the derivatives market.
Derivatives – Success in Excess
A derivative is an agreement to shift risk. Their worth is determined by the value of an underlying asset such as a commodity, an interest rate, corporate stock, an index or a currency. Stock and futures options are common examples.
As Figure 3 shows, the value of interest rate (IR) and currency derivatives in 1987 totalled $865.6 billion. Since then the market has doubled in size every 2.2 years on average. This compares to an average doubling rate of 3.5 years for the Nasdaq market between 1990 and 2004. The Nasdaq rivalled the IR/currency derivative growth rate briefly during the bubble years from 1998 through 2000 when it was doubling every 2.07 years but, as we all know, this wasn’t sustainable. By the end of 2005, the value of these derivatives had grown to nearly 20 times the size of the total annual GDP output of the United States.