Yellen about instability

Last week I wrote a piece about current market volatility and wondered whether the recent volatility wasn’t good for us because it meant that their were less correlated bets in markets that might need to be exited if things go awry – Greek default, US Equity swoon or something we haven’t thought of, a black swan.

But a speech delivered in Tokyo today has me wondering if I haven’t underestimated the other side of the correlated bets, the thing that really gets the market moving when they are unwound – leverage.

To this end Janet Yellen gave a speech titled “Assessing Potential Financial Imbalances in an Era of Accommodative Monetary Policy”  For those who don’t know Yellen she is both one of my favourite central bankers and also Vice Chair of the Board of Governors of the Federal Reserve System (FOMC).  It is an interesting speech insofar as she is putting the first shot across the bow, by a Senior global Central Banker, that imbalances are brewing in markets at the moment, right here and now.

Yellen highlighted

“signs of valuation pressures in some markets and a moderate increase in leverage provided by dealers”

An interesting point for us, in terms of previous comments from Yellen that the Fed isn’t blowing bubbles , was is that she admitted that the Fed was, in our terms – blowing bubbles, when she said the Fed’s actions to push down Treasury and private rates was intended at,

“supporting home values, equity prices, and other asset prices. After all, this is the primary mechanism through which monetary policy in its conventional form stimulates the economy. But a sustained period of very low and stable yields may incent a phenomenon commonly referred to as “reaching for yield,” in which investors seek higher returns by purchasing assets with greater duration or increased credit risk.”

That is a huge concession in light of the speech we covered in the link above over at MacroBusiness some time ago.

To me this means that the risks to markets and the global economy are growing from increased risk taking, leverage and are accordingly at the mercy of a potential Greek or Irish default or even something as vanilla as a further slowdown in the US economy which is clearly on the way. Let’s not forget the clear and present danger from European sovereign risk woes as Greece teeters toward some form of default.

In terms of leverage Yellen makes the pertinent point that

One of the lessons of the financial crisis was that the potential adverse effects of a rapid unwinding of financial imbalances, regardless of the causes, are significantly increased if market participants employ significant leverage. In the extreme, changes in investor sentiment can lead to a withdrawal of liquidity, rapid declines in mark-to-market values, forced asset sales in the face of margin calls, and, ultimately, a rapid and disorderly self-reinforcing deleveraging.

Where the rubber hits the road and where the risk lies is that like the so-called “great moderation” market players now are being lulled into trades that they would not normally make – or is it that old silly habits die-hard? Yellen says

Nonetheless, two dynamics with respect to the use of leverage bear watching. First, important classes of generally unlevered investors (for example, pension funds) are reportedly finding it difficult in the present low interest rate environment to meet nominal return targets and may be reaching for yield by assuming greater interest-rate and credit risk in their portfolios. While some investors have also apparently boosted returns by increasing leverage, we see little evidence at present that this behavior is occurring on any significant scale. Second, additional funding is reportedly broadly available to traditionally levered investors such as hedge funds. To the extent that investors choose to take advantage of the readily available funding for less liquid assets, their use of leverage could rise quickly, increasing the risks of a disorderly deleveraging.

Yellen concludes that there is little to worry about the fact that even if it’s at the margin investors are reaching for the old tools of leveraged bets when combined with markets and economies at the point where we believe the fingers of instability are growing is a potential financial molotov cocktail.

My feeling for the need for circumspection at the moment has just been increased.

greg@lighthousesecurities.com.au

www.twitter.com/gregorymckenna

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  1. Weekend Reading – Stuff we found interesting this week | Lighthouse Securities - June 4, 2011

    […] Janet Yellen changed her tune on the effect of the Fed’s QE but scared us about neophytes using leverage. We blogged here   […]

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