PIMCO’s Paul McCulley argues three central bank policy pre-commitments removed three major risks from the global markets over the past few years: 1) Starting in 1995, the PBOC pre-committed to absorbing dollar depreciation risk via a pegged exchange rate regime for the Renminbi. 2) Starting in February 2001, the BoJ pre-committed to absorbing Japanese short-term interest rate risk via its Zero Interest Rate Policy (ZIRP), reinforced by its Quantitative Easing (QE) policy. 3) Starting in August 2003, the Fed pre-committed to holding short rates accommodative for a “considerable period and after that to hiking only at a measured pace”. The result: a concerted global reflationary monetary policy that induced private sector agents to more risk seeking behaviour, i.e. moral hazard. Moreover, surveys conducted by Miller/Weller/Zhang before 2001 show that investors’ perceptions of portfolio insurance by the Fed were already engrained, fostered by its decisive actions taken during the stock market crashes in 1987 and 1998 respectively.
These ‘insurance’ effects are measurable. Research by Nobuyuki Oda / Kazuo Ueda shows that the BoJ’s monetary policy strategy has worked mainly through lowering the expectations component of interest rates as compared to the risk premium component. Miller/Weller/Zhang argue that the ‘Greenspan put’ is one potential explanation for the historically low risk premium in the U.S. stock market – i.e. investors believe that the Fed will provide a general downside guarantee on stock values by vigorously preventing the stock market from falling below a certain level but not to stop it from rising. McCulley extends this analysis to the bond market, cautioning that bondholders will only accept central banks’ stockholder rescue campaigns in times of declining asset prices if they are assured that any ensuing signs of inflation acceleration will be fought equally aggressively. Technically, this amounts to “central banks de facto shorting both a deflationary put at the bottom of their inflation comfort zones and an inflationary call at the top of those comfort zones.” The result: “with policy makers removing sources of volatility risk from markets, actual volatility falls thus pulling risk premiums – the market compensation for underwriting volatility – lower.”
As a consequence, these policy-induced low risk premia encourage investors to take on additional risk in their search for yield. Raghuram Rajan detects four main types of behavior that enhance the pro-cyclicality of the financial system: 1) Risk shifting: shifting portfolios, particularly those held by insurance companies and pension funds, towards higher-yielding, thus riskier, assets or instruments in order to meet pre-contracted rates of return on their liabilities, since the risk-free yield is now very low; 2) Tail risk seeking: selling disaster insurance in derivatives markets that produce positive returns most of the time as compensation for a rare but disastrous negative return; 3) Herding: engaging in short-term remunerative bets at the expense of diversification; 4) Illiquidity seeking (“poor man’s alpha”): taking advantage of the ample liquidity supply to engage in financial arbitrage activities with less liquid instruments or markets, such as emerging markets or commodities. All these strategies are greatly enhanced by the use of derivatives. Table 1 shows their exponential growth in line with the liquidity supply commitments by central banks (OTC derivatives display a similar exponential growth pattern since 2001).
The exact impact of the rapid growth in derivatives and non-bank institutions on the traditional transmission mechanism of monetary policy through the banking system is not fully understood yet. Based on research by GaveKal, John Mauldin from InvestorsInsight suggests that additional leverage, in the form of carry trades for instance, adds to the velocity of money which measures the amount of economic activity generated by a given money supply. Table 2 shows that the GaveKal velocity indicator exceeds the indicator for central banks’ money supply by a margin reminiscent of the dot.com-bubble or the Asian crisis. At some point, the withdrawal of liquidity by central banks will increase the cost of borrowing to the point where a sudden de-leveraging of positions is warranted, thus potentially causing a stampede to the exits.
How should policy-makers respond to the financial innovations and their pro-cyclical impact on the financial system? William White from the BIS proposes a new framework for macrofinancial stabilization that would reintroduce quantitative measures such as liquidity requirements, loan-to-value ratios, collateral requirements, margin requirements, and tighter repayment periods. However, Jane D’Arista from the Financial Markets Center criticizes the proposed framework as somewhat incomplete since the quantitative measures it recommends would apply only to banks, whereas the excessive leveraging within the fast-growing non-bank financial sector has become a distinctive problem. Special reserve requirements for leveraged transactions should therefore be considered for all financial institutions as a means of containing speculative excesses. McCulley suggests that monetary policy is part of the answer: while the provision of some insurance against volatility by central banks can be stimulating and at times even necessary, the big share of volatility risk should be left with the markets. Market participants may complain, but the taking on of risk is their raison d’être. For Rajan, the top priority belongs to containing the spillovers this policy-induced search for yield can cause to emerging markets and developing countries. Since emerging markets offer international investors both risky and illiquid assets, they are particularly exposed to a change in interest rate expectations. The recent turmoil that hit emerging markets and saw the former biggest gainers post the biggest losses can indeed be seen in this light.