Lessons for European periphery
Investors like to lend to peripheral Europe when yields are low, this is the case now similarly as ahead of euro-crisis, not when yields are high. Any lesson to be taken? When rates are low, risks of its spike are rising and everybody is worriless thanks to visible fundamentals, it pays off to step out of herd and get ready for higher rates. To be two steps ahead of markets in the period of trend reversal is costly but to be a step behind costs more. It was the case in euro-crisis and it is the case in interest rates now.
Greece returned back to bond market in April after four-year exile and demand for its bonds was huge. Portugal is exiting its rescue program without pre-cautionary credit line. Bond yields of peripheral countries are marking new all-time lows almost daily. Greek bankruptcy, the fears from Eurozone break-out and high public debts are forgotten for now. Investors love peripheral bonds almost as much as before the euro-crisis. The extreme swings between optimism and pessimism toward peripheral countries give good lessons how herd psychology can result in large losses in the time of big trend reversals. The lessons were valid for euro-crisis and are now valid for interest rates:
A. It pays off to ignore growing risks but only for limited time-period.
B. There are always reasons to ignore a new market trend even long after its beginning.
C. To wait for clear confirmation of a new hostile trend and then to act not only means losses but also locking into the hostile trend without potential recovery of losses.
IT PAYS-OFF TO IGNORE RISKS FOR SOME TIME
Remember the time before euro-crisis. Greece, Portugal and other Southern- European countries were darlings of investors. Investors had funded higher yielding assets in periphery by low rates in Eurozone without the threat of a falling drachma, escudo, peseta or lira. When Southern economies were booming and external deficits were widening, there were people telling that such a big carry-trade would end-up in tears.
Most people ignored such warnings. Macroeconomic fundamentals looked okay. Budget deficits and public debts were on declining paths. External deficits looked irrelevant in the time of common currency. Moreover, it paid-off to ignore the warnings. Paying attention to warnings was a pain trade. Either in the case of selling real-estate in Spain and looking at prices rising further up, or hedging against rising bond yields in Greece and paying higher rates. As proverb says: ‘Who is one step ahead of market looks like a genius. Who is two steps ahead of market looks like an idiot.’
TIMING THE TREND REVERSAL
To be one step ahead of markets, when large market trend is reversing, it demands to be a genius with a lot of luck. To ignore warning signs and later to time well market trend reversal is beyond ability of most people. It is very difficult to recognize a new trend and act upon it even after the first large move. Remember when bond yields of peripheral countries started to rise in 2008. It was not perceived as starting euro-crisis but a side effect of global financial crisis.
When bond yields of Greece and of others resumed to climb in 2009, there were always a lot of arguments that the prices are moving because of speculators but the countries fundaments are sound, that the ECB, Commission and IMF has everything under control. Later one more argument said that the problem is only in Greece – cooking statistics – and later the list of problematic had expanded.
WAITING FOR A NEW TREND TO BE CLEAR
When it became obvious how serious the problem with Eurozone is, when news about euro-crisis was on TV and in papers every day, when even guys in country pub talked about Grexit, when simply said risks materialized, it was too late to hedge against the risks. Pre-crisis prices were not available. That time bond yields of peripheral countries was more than 10%-points above Bunds and Greece defaulted. To be two steps ahead of market does not look like wise but to be a step behind the market can cause catastrophe.
Acting when everything was fully visible not only prevented losses but also lockedin hostile trend with no relief after crisis peaked and new trend from 2012 brought partial recovery of losses.
DÉJÀ VU IN INTEREST RATES
The current situation in interest rates has many similarities with bond markets in peripheral Europe before euro-crisis. Interest rates had been on declining path. Prevailing expectation is that rates are to stay low for long. If some increase in rates occurs, it will not be much. Central banks are trying to produce higher inflation but without lasting success. Moreover, anybody who has prepared against the risk of rising rates, she pays ‘uselessly’ higher rates. To be two steps ahead of the market does not look like wise.
The current interest rate curves are pricingin visible macro-economic fundamentals, especially zero inflation and weak credit growth. The curves are not pricing-in a possibility that central banks’ effort to create inflation succeeds even with delay. Moreover, the curves are not pricing-it at all a real possibility that central banks’ effort will be too successful.