The mispricing of risk
May 11, 2013
‘Is there more to come?’ It was with this question in mind that I gave my first book the provocative title, Between the Crashes.
Launched last month with the support of ConservativeHome, Between the Crashes provides a timeline of the seismic political and economic events that followed the collapse of Lehman Brothers in 2008. In doing so, it pulls together some of the overarching themes set to define the early part of the twenty-first century – the shift of power eastwards, generational division, disillusionment with capitalism and the political class and, most of all, the consequences of Western debt.
As I came to write the book’s conclusion in December, I was struck by a sense of how a crisis which began half a decade ago may still have much further to unwind. Today’s low interest rates and rounds of quantitative easing have lulled us into a dangerously false sense of security, parking rather than solving some of our biggest problems. Yet they are, in truth, a sign that the British economy remains on life support. It is entirely possible that excessively loose monetary policy, alongside the racking up of ever more debt, will eventually lead to another great jolt.
This fear was only compounded by a seminar I attended some months back at Gresham College, ‘The City’s Great Financial Scandals, Past & Future,’ which was rounded off with a compelling lecture by a banker with over forty years’ frontline experience. There are two types of financial scandal or disaster, he suggested. The first might cause great pain to those closely linked to the failed institution(s) but have no wider impact on society. The second, a collapse of such magnitude that financial calamity leads to social discord. This might be characterised as the difference between the failure of Equitable Life, which caused considerable pain to policyholders but had little wider impact, and the implosion of Lehman Brothers which was the catalyst that exposed the unsustainable nature of the West’s debt bubble and whose consequences we are still dealing with today.
On this basis, our lecturer feared we might well be in the throes of the latter type of crisis by the decade’s end. Why? Because in the current climate, when all the normal market signals have disappeared under a mountain of cheap money, it remains nigh-on impossible to make a rational investment decision. Risk is always and everywhere mispriced.
The classic role of economists, governments and central banks is to promote a stable monetary and legal framework that lubricates the economy with trust, the most crucial ingredient in any economic transaction. In the absence of such a framework, any asset related to a central bank agency is not capable of being properly priced; as a consequence, no rational risk assessment can be made of it.
So how are today’s central banks doing when it comes to providing such a framework? Not all that well if we look at their current aims. The US Fed has accepted an employment target around which to frame its interest rate policy; the Bank of England aims to achieve a nominal GDP; the European Central Bank does whatever it takes to save the single currency. None of these goals has the maintenance of trust at their heart. The misguided manipulation of the price of money via interest and exchange rates, added to the printing bonanza of quantitative easing (£375bn and counting from the Bank of England), has stolen from the market its ability to signal to investors what is risky and what is not.
How might these seeds grow into financial disaster? As ever, we need to follow the money. Since the beginning of 2008, investors have parked over $1.1 trillion into the supposedly safe haven of bond mutual funds and exchange-traded funds. To give some comparison, that is thirty-three times more than went into equity funds during that period. Earlier this month, yields on ten-year UK gilts fell close to their lowest level since August. It is a similar story for German and US gilts. Indeed if you look at any long run analysis of interest rates on UK government debt (say, fifteen year term bonds) – whether examining the three-hundred-odd years since bonds were introduced or even the period since the Second World War – the mean average interest rate is 5% to 6% versus the 2% today. Are we really saying that the risk of buying bonds is at its lowest level for three-hundred years? Moreover, do today’s prices remotely reflect worth?
Over the past few decades, bonds have been seen as virtually ‘risk-free,’ fixed-income investments. It was perhaps entirely understandable, therefore, that in the volatile, post-Lehman world investors would take fright at unpredictable share markets and turn instead to unexciting, stable bonds as a safe means of preserving capital and getting a guaranteed return. Nevertheless, when coupled with a new world of ultra low interest rates and active bond-purchasing by central banks, bonds began to give equity-like returns, leading to a boom in post-2008 bond sales that drove prices up.
Such investments have not been risk-free, however. In fact their over-valuation leaves purchasers vulnerable to clear, specific risks – most of all, the risk of inflation. When consumer prices rise, the fixed interest from the bond loses some of its real purchasing power. If yields are high enough, those price rises can be accommodated without losing an investment’s initial value. If not, the bond is actively destroying that value. Inflation also increases the likelihood of central banks hiking interest rates, making other investment comparably more attractive. The ostensible security offered by fixed-income bonds can soon evaporate away.
An end to ultra low interest rates and bond yields would of course be indicative of a return to some sort of economic normality. But if such things came to pass, one fund manager predicts that it is quite possible bondholders could lose up to 40% of their money. ‘So what?’, we may be inclined to ask. Well it should be noted that typically bondholders are not simply banks and insurers. They are just as often institutional pension funds (funds which reportedly now own more bonds than equities). The mispricing of bond risk, caused in large part by the manipulation of the money supply by central banks, could potentially lead to the destruction of savers’ capital on a massive and unprecedented scale.
If interest rates were simply to revert to their long run mean average, a portfolio held in such bonds would devalue by between 35% and 44%, even if inflation stayed at the roughly 3% it is at today. If inflation took off as well, there could be a devastation of bond values. Yet pension funds, insurance companies and banks have all been encouraged to hold ever more of these supposedly ‘safe assets’. It is vital that governments cease pushing through legislation based on Basel III and Solvency III that force the holding of these bonds on pension funds, insurance companies and banks. Beyond that, it is imperative that investors be made aware of the risks – and fast. It is interesting to see this week that the portfolio managers of a number of US university endowments have drastically reduced their exposure to US government bonds from as much as 30% in 2008-09 to near zero in many cases. Nobody wants to be last in line should this be the start of a headlong rush out of the market.
The crisis kicked off by the Lehman’s collapse was brought about by an irrational exuberance, most obviously in the housing market, that made it difficult for investors to make rational risk/reward investment decisions. The next ‘crash’, if it came about in our bond markets, would instead be as a result of deliberate government economic policy.
But would such an outcome lead to social calamity? We can only hope not. Yet history is littered with periods where the debasement of money (hyperinflation) – and therefore the debasement of trust – has gone on to undermine social cohesion, not least as it has first wiped out an aspirational middle class. A widescale destruction in the value of pension funds triggered by a bond crash would coincide with the erosion of debtors’ liabilities by inflation. This would likely trigger a deep sense of injustice as savers and the responsible in society lose out to the profligate.
Worryingly, the Bank of England is now controlling the supply, demand and price of bonds in the UK. It seems unthinkable that this is a prescription without consequence. The fear that we remain ‘Between the Crashes’ still looms all too large.