Home' Trinidad and Tobago Guardian : August 21st 2014 Contents BG22 COMMENTARY
BUSINESS GUARDIAN www.guardian.co.tt AUGUST 2014 • WEEK THREE
Last week s article was titled,
Rumors of War. This column is
written four to five days before
it is published. On the day that
you were reading the column
last Thursday, four days after it
was written, tensions began to escalate in the
Ukraine resulting in the yield on the ten-year
US Treasury bond falling below 2.40 per cent.
The following day (last Friday) there was a
further drop intra-day to a low of 2.30 per
cent eventually closing at 2.35 per cent down
2.29 per cent for the day. I consider a close
below a yield of 2.37 per cent to be significant
from a technical stand point as a key support
level has now been taken out.
It also means that twelve months on I have
forecasted more accurately than most other
commentators in the industry when I suggested
that the range for the ten-year bond would
be 2.20 to 2.60.
While the geopolitical tensions make the
headlines, I want to look beneath the headlines
to expand on a point I was making last week.
In using the term "currency wars" to describe
the competitive devaluation of currencies
amongst the developed countries of the world
in order to boost their respective economics,
I was implicitly making the point that there
is a war of a financial nature currently taking
I draw reference to the work of the governor
of the Reserve Bank of India, Raghuram Rajan,
in expanding on this argument. It was Rajan
who, in 2005 while at the International Mon-
etary Fund, made the case to the financial
community in the US that increased use of
credit default swaps and mortgage backed
securities made the landscape more risky,
which went against the thinking at the time.
The 2008 financial crisis proved him right
and I have on a couple of occasions referenced
his 2010 book, Fault Lines -- How Hidden
Fractures Still Threaten the World Economy.
It is a book that I would recommend reading
up to today.
Rajan is again making headlines by sug-
gesting that the global economy is at risk and
could result in another financial market crash.
Before getting into the details, let me indicate
that I share this view and have commented
on these risks many times over the past few
From an investor s point of view in terms
of managing and placing funds, the United
States markets represents what can be
described, as "the cleanest dirty shirt", so while
we may talk about these global risks the market
that is currently in the best position to work
through those risks is the United States of
America, even though they also have challenges
to deal with. That is why their ten-year Treas-
ury bond yield is so low, despite the moves
by the US Federal Reserve to reduce their level
of monetary accommodation to the market.
Investors mindful of the risk in other markets
and in other currencies see the US as a safe
haven and these inflows are being reflected
in the current market conditions.
Yet it is not all clear cut and the situation
changes with each news headline. It was just
in June of this year that there was US$40.8
billion net selling of US Treasury bonds by
foreign private investors lead by China and
Japan. This represented the largest outflow
on record and was part of an overall record
outflow of US$153.5 billion. Based on current
yields, it is clear that the trend has reversed
as money is now flowing back into the US.
According to Rajan, the global economy
resembles the 1930s as developed economies
are working to escape their respective versions
of "The Great Recession" at each other s
expense. He is seeing a zero sum game, which
is likely to end badly with the key, nuanced
element, being that instead of genuine demand
being created across the globe,there is instead
the shifting of demand from one region to the
next based on currency and interest rate machi-
The spill over effects of this lack of coor-
dination will be greater turbulence and if it
happens sooner rather than later, then it will
be coming at a time when the global economy
is less capable of bearing the cost associated
with this turbulence.
The longer rates stays at these depressed
levels the greater the risk of investors chasing
higher yields and misallocating capital. The
catalyst for this type of behaviour, which, to
the rational observer, will be seen as reckless,
is the fact that central banks have been sup-
portive of the financial markets to the extent
that any hint of a market disruption has been
met with protection from the central bank.
One example of the way imbalances are
occurring is with the euro, specifically the
strength of the euro in the context of the weak
economies that make up that bloc. The United
States, United Kingdom, China and Japan have
all taken steps to effectively "print money",
thus causing their currency to depreciate. The
European Central Bank, by virtue of the fact
that it represents many different sovereigns,
cannot engage in such action, at least not as
easily as other central banks.
As a result the euro has remained at elevated
levels relative to the other major currencies
of the world. All of the US, UK, Japan and
China have managed to achieve varying levels
of inflation from their central bank policies.
Given that deflation was the biggest risk of
the financial crisis, it appears that these coun-
tries have managed to export this deflation
risk to the Euro Zone.
This deflation risk is the reason why the
benchmark ten-year yields for European sov-
ereigns are so low. As at last Friday the UK
was at a yield of 2.32 per cent, while Germany,
France and the Netherlands were at 0.95, 1.34
and 1.13, respectively. Reference this against
the 2.35 in the US. Beyond that is the situation
with the German two-year note, trading at a
negative yield of -0.158, which means that
investors have to pay to hold this German
According to Rajan, these types of yields
for the extended period that they have been
in existence can cause problems in the same
way that low yields lead to the housing crisis
in the US.
In a recent quote in Time magazine, he said,
"My greater worry is that by altering the price
of capital for a substantial period of time, are
we also, in a sense, distorting investment deci-
sions and the nature of the economy we will
have. Have we artificially kept the real rate of
interest somehow below what should be the
appropriate natural rate of interest today and
created bad investment that is not the most
appropriate for the economy?"
The cheap money floating around the world
is also meeting up with many global "hot
spots" to create points of great uncertainty.
Those with an understanding of history will
appreciate that the map of the Middle East
is being redrawn in much the same way that
Europe has experienced over centuries.
The epicenter of all of this is Iraq, which
is now a country in name only. The post-
Ottoman construct of the British, which was
violently held together by Saddam Hussein,
is now splintering. It is only a matter of time
before there is a Kurdistan in the North. This
will then have a knock-on effect on the Kurdish
minorities in Turkey and Iran. A Shia Muslim
enclave will form in the South, which will
empower the Shia Muslim minorities to their
west and represent a proxy for Iran. The Sunni
Muslim group in the middle of Iraq is caught
in the Syrian civil war with no clear end or
objective in sight.
As the map of the Middle East is being
redrawn instability will be the order of the
day. History has shown that the developed
countries have become more interventionist
the more their economy struggles. It has often
been suggested that the Great Depression in
the US ended not because of monetary and
fiscal policy, but rather as a result of World
Much of this discussion involves an amount
of speculation. The future is unknown. Yet
having the discussion accomplishes two things.
First, it provides a level of perspective in
the event that some of these issues were to
come become more pronounced.
Secondly, it re-emphasises the need to man-
age the risk of outlier events in your investment
portfolio. If you are not certain of how to do
this, then you should consult with an invest-
ment adviser who knows.
Ian Narine can be contacted via
Managing the winds of change
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