Risk-free returns or return-free risks?

If the recent market turbulence originated in the sharp correction in Chinese equity prices and the devaluation of the yuan, could the next one be triggered by bond market mutual funds suspending redemptions?

Just as the global economy is absorbing the repercussions from the Chinese devaluation and stock market gyrations, could we face another major upheaval, this time arising from the bond markets in the advanced countries, when the central banks in the US, Japan, and the euro zone start raising interest rates from today’s near zero levels? While such action in Japan or the euro zone is hardly imminent, there is increasing speculation about the US Federal Reserve increasing interest rates next month or, in any case, in quarter IV.

On the one hand, Lawrence Summers, former treasury secretary, and Ray Dalio, the world’s largest hedge fund manager, are arguing for further quantitative easing through a new bond buying program; on the other, Avinash Persaud of the Peterson Institute, has argued for raising interest rates: his rationale is that the extremely low yields have led investors into buying risky, higher yield securities; invest in "covenant-lite" loans; high-risk energy industry loans; takeover finance; etc. etc.

One day, the chickens will surely come home to roost. The debate has become more heated as the Q2 GDP growth, at 3.7% annualised, suggests that the economy is robust. Stanley Fischer, the Vice Chairman of the Federal Reserve has been ambiguous in his comments in prepared speeches and interviews.

To be sure, deciphering what central bankers say is an art in itself: as Alan Greenspan once said, “If you think you have understood what I said, then I did not say what you think I said”! More seriously, when the rate rise comes, it could well have an impact on the global economy out of all proportion to the size of the change. There are several reasons for this:

1. Banks, once major players in the bond market, have reduced their exposure to government bonds partly because of the interest rate risks, and partly because of the enhanced capital requirements under Basle III;

2. Liquidity in the US bond market has come down significantly -- and illiquid markets exaggerate price changes;

3. For the last several years, investors in the bond market have made large gains as yields continued to drop and therefore prices of existing fixed income securities went up. Right now, they are facing the opposite scenario as yields can hardly drop further. In many ways, therefore, investments in US treasury bonds, instead of giving risk-free returns (coupon inflows, and no credit risks), have become return-free risks (practically zero coupons, and a huge price risk when interest rates start going up in an illiquid market)! 

4. The central bank of China, after being a huge net buyer of US treasury securities for years, has now become a seller as it needs funds to intervene in the foreign exchange market since portfolio capital in the stock market is continuing to flow out.

If the market turbulence over the last couple of months originated in the sharp correction in Chinese equity prices and the devaluation of the yuan, and reverberated across global financial markets, could the next one – or perhaps a continuation of the existing volatility – be triggered by bond market mutual funds suspending redemptions?

Recently, the Financial Stability Board was considering designating the large bond market funds as "systemically important financial institutions", which would have imposed tighter regulatory norms and capital requirements for the fund managers; the industry has managed to successfully lobby and avoid the label.

However, problems could emerge when investors start encashing their holdings in open-ended funds to avoid price losses and the funds will be required to sell the bonds in the market. Given that, as it is, the market is not very liquid, the price impact could well be large, triggering more disinvestments. In some ways, this would become a real life "stress test" for the Basle models for measuring market risk. 

Could the result be a “risk-off” mood amongst investors? What could be the impact on equity markets, capital flows and exchange rates? On the global economy? Too many questions, too few answers, other than one -- we could well be in for some very interesting times in global financial markets for the rest of the year.