Markets enjoy blessed relief now the heavy storms have passed

Investors are on the lookout for inflation signals now a calmer mood is upon us following the turmoil of 2020

Katie Martin 

After the crisis in the economy caused by the pandemic, markets are now far less volatile © FT montage; Bloomberg; Dreamstime

Financial markets are, right now, intensely dull. 

That is bad news if, say, you are a journalist newly tasked with writing a weekly column on the subject. 

Just for the sake of argument.

For most other people, however, it is a blessed relief. 

In March 2020, when the pandemic really hit and markets were in meltdown, people outside of the tight financial community were much more focused on keeping themselves and their families safe, and procuring tinned food, than fretting about equity valuations.

But that volatility has a real-world impact, as the Bank of England recently reminded us in a blog post. 

“Financial markets reflect changes in the economy. 

But sometimes they amplify them too,” the central bank said. 

In other words, markets can make bad situations worse, jacking up costs of financing for anyone trying to raise new debt or equity. 

To illustrate the point, the blog casts us back to the events of spring last year when markets were forced to swallow an enormous wave of economic disruption from global lockdowns in one gulp. 

The price of risky assets, unsurprisingly, collapsed. 

Several structural and technical issues in trading and fund management quickly made that collapse self-reinforcing.

Derivatives market participants were frequently required to post much larger chunks of collateral to counterparties — demands that reached a crescendo around the middle of March 2020. 

This triggered more selling. 

More thought on how collateral requests are calculated, with an eye on reducing the impact of vicious cycles stemming from them, might be a worthwhile exercise, the blog suggests.

It is reassuring, in a way, that nothing even remotely close to typical levels of volatility are in play now

In addition, many funds were forced in to liquidations. 

Funds, especially those focused on corporate bonds, received a surge in redemption requests. 

Meeting those requests quickly as promised was tough for funds with hard-to-sell underlying assets. 

At the peak, net outflows hit 5 per cent of assets under management for corporate bond funds in March, the biggest wave of requests since the global financial crisis. 

Again, for those funds, the only answer was: sell bonds, fast.

Leveraged bets by hedge funds, highly lucrative in the good times but quickly heavily damaging in bad, also hurt, as did intense stress among banks that facilitate trading across a range of asset classes.

All of this warrants “further investigation” the blog says, if we are to avoid similar grim situations with potential real-world effects in future. 

Last time around, only the heavy-handed intervention of central banks stopped the rot.

March 2020 was an extreme example of stress, for sure. 

Still, with that period etched in such recent memory, it is reassuring, in a way, that nothing even remotely close to typical levels of volatility is in play now. 

This keeps financing costs strikingly low and gives the global economy the breathing space it needs to recover from the shock of the pandemic.

How quiet is it? 

Absolute Strategy Research points out that the S&P 500 benchmark index of US stocks has been squashed into ever narrowing trading ranges in recent weeks. 

It moved more than 1 per cent in either direction in a single day only twice in the whole of June. 

Even then, it dropped and then jumped by a similar degree on consecutive days, so it was roughly a wash. 

New highs are close to a daily occurrence, but they arrive in tiny increments.

In currencies, the tone is similarly sleepy. 

“It is not uncharitable to suggest [major currency] ranges for the year have been paltry”, wrote Deutsche Bank macro strategist Alan Ruskin.

“It is still plausible that the euro might record its narrowest annual range against the dollar since the fall of Bretton Woods,” he said. 

The common European currency is probably on track for “a similar ignominious record” against the yen. 

Even typically livelier trades, like the Australian dollar against the yen, are also in a deep slumber.

And all this before the traditional summer lull kicks in.

Even cryptocurrencies, generally a reliable source of loopy unpredictability, are asleep. 

After a dramatic halving in the price of bitcoin earlier this year, prices have settled into a tight range around $33,000 a pop. 

Some true believers say the second Crypto Winter has set in, similar to the long slow period after the last milder boom and bust in 2017.

That, of course, could change with a single tweet from Elon Musk. 

But back in the world of more established asset classes, barring a serious inflation shock or Delta variant curveball, upbeat stability seems to be the outlook for the coming months. 

In part, says Karen Ward, chief market strategist for Europe at JPMorgan Asset Management, that is because of the faith among investors in central banks’ willingness to cushion shocks. 

“Also, we are still in a holding pattern,” she said. The big question around how long inflation sticks around, and how pronounced it proves to be, will take months to answer. 

“The data are not going to add any information on that story” any time soon, she said. 

“It could be the end of the year before we know.”

Enjoy the silence. 

It is “kinda dull”, as one commenter put it to Bank of America’s analysts. 

“But you don’t sell a dull market.”


The return of the carry trade

Interest-rate rises in some big emerging markets will entice foreign capital

If you like a central bank that responds to inflation surprises by—and here’s a retro touch—raising interest rates, then the Banco de México might be the one for you. 

On June 24th it surprised the markets by increasing its benchmark rate from 4% to 4.25%. 

Although it said in its statement that much of the recent rise in inflation was “transitory”, the scale and persistence of inflation was worrying enough to warrant higher interest rates.

Mexico is no outlier. 

Brazil’s central bank has pushed up interest rates to 4.25% from a low of 2% in March. 

Russia has raised its main rate to 5.5% in three separate moves. 

These countries belong to the high-yielders, a group of biggish emerging-market economies, where interest rates are some distance from the rich-world norm of zero. 

All three believe a lot of today’s inflation will fade. 

But none is taking any chances.

Scan the central banks’ statements, and a clear concern emerges: keeping expectations of inflation in check. 

This is in part, or even mostly, about exchange rates. 

Higher interest rates keep domestic savings onshore in the local currency. 

They also entice capital from yield-starved foreigners. 

This is called the carry trade—and it is coming back.

High interest rates are now so rare in large economies that where they occur they require explanations. 

Latin America has a history of inflation. It is hard to get people to trust a currency when memories of betrayal linger. 

A related explanation is high public debt. 

Brazil’s burden is nearing 100% of gdp. 

Fiscal incontinence in developing countries often leads to inflation. 

High yields are needed to compensate for that risk. 

But such explanations only get you so far. 

Though Poland has suffered an episode of hyperinflation in living memory, it is a low-yielder. 

Turkey’s yields are high even though its public-debt burden is well below the emerging-market average.

High yields are in the end a reflection of a lack of domestic savings, says Gene Frieda of pimco, a fixed-income fund manager. 

A telltale sign is a country’s current-account balance. 

As a matter of accounting, a deficit means that domestic savings are not sufficient to cover investment. 

Foreign capital is needed and high yields are the lure. 

Much of emerging Asia runs a surplus on its current account and has high domestic savings—and thus low yields. 

Poland and the Czech Republic, both low-yielders, were able to reliably augment their domestic savings with eu grants and direct investment from Western European firms. 

Russia, which has high yields and a current-account surplus, looks like an exception. 

But the surplus reflects its ultra-conservative monetary and fiscal policies, says Mr Frieda. 

The net effect is to raise yields and lower gdp growth but strengthen the balance of payments. 

Russia’s rulers accept this to avoid being beholden to foreign capital.

That brings us to the carry trade. 

Policymakers in emerging markets are galled by the vagaries of capital flows. 

But carry traders are their friends. 

The inflation expectations that central bankers bang on about are entwined with the exchange rate. 

A weakening currency can be a sign of anxiety about inflation. 

And in the past year, currency weakness has also been a source of emerging-market inflation, says Gabriel Sterne of Oxford Economics, a consultancy. 

So when a central bank raises interest rates, it is in part because it wants a stronger currency to curb import costs. 

This might be the quickest way to bring inflation down.

For their part, carry traders like a yield curve that is steep—meaning five- or ten-year bond yields are a lot higher than short-term interest rates. 

A steep curve captures expectations of future rises in policy rates. 

Traders also hope to bet on an appreciating currency. 

Factors other than interest rates then come into play. 

One is valuation. 

If a currency has fallen a long way recently, it has greater scope to rise again. 

Another is a country’s terms of trade, the prices of its exports relative to imports. 

Oil exporters are in favour now because of high oil prices. 

Carry traders must be mindful of influences that could blow up a currency. 

Turkey has attractively high yields, but its erratic monetary policy creates a minefield.

Brazil, Mexico and Russia are at the leading edge of a new trend. 

Economists at JPMorgan Chase, a bank, reckon that Chile, Colombia and Peru will soon be raising rates. 

South Africa will join them before the year is out. 

The Banco de México and company are not going to hang out a sign saying “carry traders welcome”. 

But they might as well put one up. 

The more their currencies rise, the less work they have to do.

Attack of the COVID Zombies

All too often, entrepreneurs and managers use the threat of massive layoffs to extract large unwarranted subsidies. After the COVID-19 pandemic, workers should get to decide whether such assistance is justified.

Luigi Zingales

CHICAGO – As Western economies emerge from the COVID-19 crisis, banks and governments are facing a new problem: how to deal with the corporate walking dead. 

But an innovative worker-centered scheme could offer a possible solution.

In both the United States and the European Union, corporate bankruptcies have declined during the 15 months of the pandemic, despite the severe accompanying recession. 

That decline is a result of rich-country governments – in their understandable desire to soften the pandemic’s economic blow – extending every possible safety net to firms. 

Often, however, they did so without even trying to separate those with good economic prospects from those with none.

As a result, the business sector’s natural selection process has weakened precisely when COVID-19 has accelerated many preexisting trends, increasing the share of firms that should be considered zombies. 

But policymakers must now address the wider economic impact of sustaining unviable companies.

Governments cannot abruptly discontinue all business subsidies, of course. 

During the pandemic, many otherwise healthy firms have accumulated a lot of debt. 

Suddenly subjecting all of them to rigid market discipline would result in a very large number of unnecessary bankruptcies.

Moreover, the economic and financial impact of an immediate cut-off of support would be politically suicidal for any elected government. 

The negative GDP shock would have severe effects on both unemployment and public finances, and the losses that a wave of bankruptcies would force on lenders would further weaken banks’ balance sheets. 

The near-certain result would be massive voter discontent, all but ensuring the government’s loss at the next election.

At the same time, policymakers cannot continue to help all zombie firms. 

Such assistance would have large fiscal costs and hamper the productivity growth that Western governments desperately need to solve many of their fiscal and political problems. 

The changes produced by the pandemic call for new and innovative firms. 

But it will be difficult for such firms to enter the market and grow if we waste so many physical, human, and financial resources in keeping zombie businesses alive.

Separating the corporate living from the corporate dead is not easy even in normal times: This is what the art of banking is all about. 

And while distinguishing between healthy and unviable firms is tricky for the private sector in the best of times, it is particularly difficult to do so now, when there is still a high degree of uncertainty about the post-pandemic world to come. 

But the private sector can at least aggressively use incentives to capture diffuse information. 

This is prohibitively tough for a government agency, especially one that lacks the necessary accumulated expertise.

This is a new version of an old problem explored most notably by Friedrich Hayek. 

As Hayek showed, the allocation of knowledge in society is diffuse, and it is difficult for any government to gather it in an unbiased way.

But there is a possible way to resolve this difficulty. 

If you want to assess the quality of a student, there is no more revealing metric than asking her classmates. 

Those who learn day in and day out with a peer can best appreciate her talent. 

In the same way, nobody can gauge the quality of a firm better than its own employees. 

To weed out zombie firms, therefore, governments should start to condition any subsidy to a company on an endorsement by a majority of its workers.

The problem is that, unlike classmates, employees have an incentive to lie. 

If the firm were to fail, they would lose their jobs. 

Because endorsing their company does not cost them anything, most will probably overstate its future prospects.

But this problem can be easily overcome with appropriate incentives. 

Under such a scheme, if a majority of workers voted to liquidate the firm immediately, its employees would receive unemployment benefits for longer. 

If they voted to continue, the government would inject some cash to make the company viable. 

But if it subsequently were to fail, the workers’ unemployment coverage would be severely curtailed – possibly to zero.

Workers who see no future for their company would prefer the longer period of social protection. 

On the other hand, those who think their firm has a future would not jeopardize it by voting to liquidate.

If properly calibrated, such a scheme would be able to separate zombies from otherwise healthy firms burdened by the effects of the pandemic. 

It would do so by making the cost of subsidies explicit: More support today means that governments may have less fiscal capacity to help workers tomorrow.

Last but not least, this system would empower workers. 

All too often, entrepreneurs and managers use the threat of massive layoffs to extract large unwarranted subsidies. 

This time round, workers should get to decide whether such assistance is justified.

Luigi Zingales is Professor of Finance at the University of Chicago and co-host of the podcast Capitalisn’t.