January 14, 2013
Today, this column is going to deploy two devices that writers often use to make themselves sound very intelligent. The first is the quote from a great thinker, which has to be both witty and knowing; and the second is exposing the classical origin of a well-known word, which only a man of either great scholarship or access to Google can appreciate.
With the aid of these two tools, we will look at the recent giddiness surrounding the prospect for the Irish government bond market, which has had the green jersey brigade bellowing out the economic equivalent of Ireland’s Call with all the patriotic vigour of the West Upper ahead of a showdown with England.
So here goes. Don’t say you haven’t been warned.
At the height of the Great Depression, when financial markets were bouncing around all over the place in search of a trend, Keynes observed: “These markets can remain irrational longer than you can remain solvent.”
Keynes, the great philosopher, economist and stock market gambler, was trying to make some sense of the short-term moments of the market, which were rallying on precious little real positive data, and then selling off dramatically on – again – precious little negative data.
This meant that the markets back then were being driven by irrational sentiment. It was this sentiment which Keynes feared, noting that the rational investor, who assesses the data and tries to make investments based on real evidence, could go bust waiting for the irrational markets to validate his analysis. This is the uncertainty – or the essential hazard – implicit in the financial markets.
Armed with this observation, let’s look at the etymology of this word hazard. Hazard comes from the Arabic game ‘az-zahr’. This was a highly popular pastime of the Moors of Andalucia before the Christians decided to kick them out of Spain. (This ethnic violation robbed Spain of its Arabic and Jewish business acumen, condemning Iberia – after a brief heyday of post-colonial gold looting – to become the economic backwater of Europe.)
Az-zahr comes from the Arabic for bone because knucklebones were used as dice in one of the first rudimentary gambling games. Skeletal knucklebones were rolled – the first roll of the dice – and people gambled on which side would show up in the same way as we gamble the numbers of the dice.
So hazard or risk, the currency of financial markets, comes from the ancient Arabic game of knucklebone-rolling. There is always risk because this is what makes the financial world go round.
The financial world is driven by sentiment, which Keynes understood so well, and the optimism of a gambler is normally also a function of how his run is going and what the rest of the herd is doing. When things are going well, he gets greedy, believing that his run of good luck will last, and when things are going badly, the opposite can occur. He oscillates between greed and fear.
Now what happens when everyone is greedy and no one is fearful? Asset prices, particularly risky assets like Irish government bonds, rise, because traders believe that risk has disappeared. They therefore take positions in risky – rather than secure – assets.
What is happening in today’s global financial markets? Something odd is happening, because perceptions of risk have collapsed at a time when there is still quite a bit of economic uncertainty.
Let’s use two indices to quantify how the irrational markets are not gripped by fear but pumped up by greed.
The first is the VIX index, which measures how the markets think the next 30 days is going to pan out through measuring bets taken today on what next month is going to look like. It is widely used in markets to gauge perceptions of risk. What we see from last week’s reading is that the markets are behaving as if risk has being eliminated worldwide.
The VIX index spikes upwards when the markets are fearful and when there is lots of risk, and downwards when something happens which causes the markets to believe risk has been reduced.
In the past two weeks, the VIX index has fallen by an enormous 37 per cent. It is now at its lowest level since 1991. This means traders are taking risky positions driven by their belief that risk is low.
The other index is a lovely little index used by CNN money. It aggregates seven specific indicators of market direction from the momentum of shares themselves to the gap between junk bonds (like Ireland) and safe bonds to the ratio of put options (options to sell) to call options (options to buy).
It aggregates these together to assess whether greed or fear is dominating the irrational sentiment that Keynes warned might remain so long after the traditional investor goes bust.
And guess what? The index is now showing extreme greed. Last week saw the highest level of greed ever recorded by CNN. It means the market sees no risk anywhere, skies are blue and the future is rosy.
Why could this be? The answer lies in the behaviour of world’s central banks and their zero-interest rate policy. The New Year was trumpeted by the Bank of Japan saying it would print as much money as it needed to facilitate the government’s aim of raising the rate of inflation in Japan. The markets know this means trillions of surplus yen are sloshing around, so why not borrow these yen at zero interest rates and buy other assets which yield higher and pocket the difference?
All across the world, central banks are doing the same. The Fed and the Bank of England are printing as if it is going out of fashion while, in Europe, the ECB’s “outright monetary transactions” policy means the central bank will buy almost any government bonds which, in this market, is simply encouraging the gamblers to follow suit. Free for all.
What has all this to do with the recent high-fiving that the green jersey brigade has been giving each other over the fall in Irish bond yields and the flogging of some Bank of Ireland bonds?
It implies that the markets worldwide are buying anything that offers yield, and Irish bonds offer yields. But does it mean that the economy here is improving, as suggested by the spin put out by the government? Clearly not. When you roll up all debts, we are still the most indebted country in Europe. The fall in Irish bond yields is a function of the global greed indicator being close to maxed out.
When you stand back, you can see the main risk in financial markets today is that there is no risk.
The collapse in bond yields is like the peaking of the housing market here in 2006. It is driven by a tsunami of cheap money looking for a home, rather than anything real.
Given this, I am sure that Michael Hasenstab, the US fund manager who owns large sections of our bond market, is now thinking of selling. So expect more glowing utterances from him, amplified by the echo chamber of spin and media cheerleading here.
Every time you hear this chorus, you can bet your bottom dollar that Hasenstab is now thinking of selling, not buying.
“Shoulder to shoulder” and all that jazz.
David McWilliams’ new bookÂ The Good Room is out now.