According to the performance of the major stock market indices (DAX, Nikkei, S&P 500), we might think that the markets have recovered from the shock, caused by the sharp drop in August, so the bull market continues. Some asset classes and submarkets show another picture.
I wrote about it in October, that the improvement of the American market is not based on a wide range, several previously leader sectors (ex. Pharmaceuticals) could not approach again the peak achieved in the mid-summer. Besides this, the deteriorating structure of the market is reflected also in the Russell 2000 and DJ Transportation Indices’ performance, which are composed by stocks of middle sized companies. These indices perform much weaker than the S&P 500 Index, which is pulled by less and less company stocks. A worrying sign is as well that junk bonds are significantly underperforming the high-quality bonds. Now I would like to draw the attention to two phenomena: a) to the evolution of the difference between the yields of the interest rate swaps and the US government securities; as well as b) to the raise of the financing cost of implied dollar surplus, which is above the interest rate differential of the cross currency swap transactions. Both phenomena refer to a growing stress situation: the U.S. Dollar’s liquidity is narrowing.
In a normal situation the yield on the American government securities is below the yield on swap transactions with similar maturity, by (10-20) basis points. (The swap is a derivative contract through which one party pays fixed interest rate on full maturity to another, who pays variable interest rate, quarterly, the actual 3-month interbank interest rate, the LIBOR). Now, however, the yield on long maturity swaps fell below the bond yields.
In theory a situation like this cannot be maintained, because it opens a (quasi) arbitrage1 possibility. Who possesses money should buy the American 10-Year Government Bond and a swap (for paying the fixed interest rate); so in the current situation anyone can earn a risk free LIBOR + 16 basis point yield. Of course, the transaction costs will take away part of the extra yield, but not significantly. So why aren’t the market participants doing this? Probably they are doing it, but fewer than before. Certainly the number of participants who have a lot of money for these kinds of transactions is decreasing and probably others could borrow money harder, from more expensive sources. Namely, money is needed for buying bonds, and – as we can conclude from the chart above – it seems, that there is less cash now. The reason for this situation was that for banks do not worth to open these kinds of positions, because of the changes in regulations (higher capital requirements; moderation of security transactions with commercial goals).
Not yet in the US, but in Hungary in the last decade we could observe already a similar situation. During the 2008-’09 crisis, there were so few investors, who had cash for buying Hungarian bonds, that the difference between the yield on the 10-Year bonds and the yield on the so called asset swap spread increased to 300 basis points for a short time. (In Hungary there were other reasons for the growth of the asset swap spread as well, such as the liquidity and risk level of certain instruments, the compulsory conversions of the pension fund portfolios; but bank regulations – and the ordinances of some parent banks – have been important factors on the domestic market too).
A long time ago in Hungary, after the long naught, the asset swap spread, which has grown to a 50-60-70 level, seemed as a very attractive investment opportunity. Then it had been realized, that there was an even better investment opportunity for this “quasi arbitrage” transaction. We cannot know how long will last this trend, started in August, in the US. The current American situation might refer to the fact that there are more sellers on the bond market in comparison with the swap market. We may see the effect of the Central banks’ intervention on the foreign currency market, or the effects of the transition of the repayments of emerging markets’ debt. Anyway, it is worth to keep in mind that in Hungary the growth of the spread started already at the end of 2007. This is not a good sign.
It’s not a good sign what is happening on the cross currency swap market either. (The cross currency swap means when one party gives its foreign currency to the other party in exchange for another foreign currency; the foreign currencies will be exchanged back on a previously fixed cross exchange rate at the end of the period. From the difference between the two exchange rates –or in the case of a longer period, from the paid interest- is given the “implied interest rate difference”. Normally this should be equal to the difference between the two currencies’ interest rates. In the current situation the implied interest rates on cross currency swaps differ from the difference between the currencies’ interest rates, the so called base is not zero. Moreover, facing the Dollar, it is negative and increases in absolute terms.
The trend on the graph above shows not only the EURUSD cross exchange rate, but also all the foreign currency exchange rates against the Dollar; and not only on the short term, within one year; but on long term transactions as well. The negative value in the case of EURUSD means that: who has euro resources/deposits (for instance a bank in the Eurozone) and needs Dollar, has to pay besides the interbank interest rate difference, 0.4% of interest rate as well, for one year. So the Dollar creditors are in a favorable situation, while the debtors have to pay the premium.
This phenomenon has several reasons as well. It might be related to the fact that more and more companies start to issue bonds in Euros, or the Central Bank’s bond purchases may affect it as well. But one thing is clear: the liquidity of Dollar is decreasing, today it’s more expensive to gain any USD (by foreign currency exchange), than 1-2 years ago. We could already see a situation like this in Hungary, after the financial crisis. That time, suddenly, financing the Swiss Franc became much more expensive.
The above mentioned processes are the most painful for those who are indebted in Dollars; this is the situation in the case of the majority of the emerging markets (mostly companies). It is very relevant my college’s remark, Citadella, that: “the Dollar is the emerging markets’ Swiss Franc”. Considering this is not surprising at all that after the fall in August and then after the quick boom, the emerging market stocks couldn’t follow this increase. If the mood will become bad, then this relative weakness may transform into a decrease. According to these it wouldn’t be surprising if in the following months the emerging market stocks would fall to new low points.
1In my opinion, there is no such thing as pure arbitrage in practice, because there will always be a risk, which cannot be eliminated previously. But at the same time there are some very attractive risk yield and “quasi arbitrage” combination transactions.
Original date of Hungarian publication: November 24, 2015