Investors and policy makers generally seem to recognize that the prolonged period of low interest rates and low volatility provides fertile ground for its opposite. It facilitates excessive risk taking. The excessive risk taking can take on many forms and employs various vehicles.
Recently Yellen singled out a couple of sectors in the equity market that may excessive. In the past, other Fed officials have cited specific sectors of the credit market, like the high yield bond market, that did not seem sustainable.
Looking at the past crisis, it seems that several have been preceded by a growing mismatch. Sometimes that mismatch is one of duration, using short-term financing to purchase long-term assets. Sometime the mismatch can be in the excess leverage, which can make even the well capitalized participant capital-scared. Sometimes the mismatch can be in quality or composition of investments, such as not truly diversified (unstable correlations), or perceiving the quality to be higher than it may in fact be.
Another type of mismatch is in the currency space. This is a function of foreign currency borrowing. When foreign interest rates are substantially lower than domestic rates, companies and governments are tempted to borrow in foreign currencies. This works well when the foreign currency, like the dollar, is falling. However, when the dollar rises, currency mismatch can be very painful.
This Great Graphic, tweeted by the UK journalistAmbrose Evans-Pritchard, shows the hard currency borrowing of emerging markets. Each bar covers only the first half of the years denoted. Clearly, there has been a steady increased borrowing in foreign currencies, primarily, but not exclusively US dollars. Fed tapering and the prospects of a rate hike toward the middle of 2015 has not slowed this foreign currency borrowing binge. This mismatch may save funding costs in the short-term, but if the dollar rises, this mismatch can turn into an Achilles’ Heel quickly.
The Financial Times’ Elaine Moore discusses similar issues about the frontier economies with Exotix’s Stuart Culverhouse in this 5.5 min Cool Video.
This piece is cross-posted from Marc to Market with permission.