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Global Crisis Blog

Three Reasons to Be Very Very Scared

By Shlomo Maital

    On a long flight, I read today’s (Oct. 28) Financial Times, then fell asleep. But I did not sleep well at all. Here is why.

  1.  UBS’s managing director of foreign exchange strategy, Mansoor Mohl-uddin, predicts that foreign exchange turnover in global forex markets (mostly dollars, perhaps 80%-90%) will reach a staggering $10 trillion a day by the year 2020, compared with $4 trillion a day today, and only about $1.5 trillion a day in 2000.  Why?  A massive flood of dollars pouring out of the U.S., as America’s Ben Bernanke, head of the Fed, engages in a risky experiment called Quantitative Easing (buying bonds in an effort to lower the long-term interest rate, after finding that the close-to-zero short-term rate was ‘disconnected’ from the crucial longer rates, so vital for investment).  Mohl-uddin says that currency markets will see much higher volatility in the coming decade, because investors will need to hedge their foreign bets against currency risk, and speculators, he might have added, will be in there as well, enjoying the rising volatility and placing strategic bets.  The size of the global forex market is so huge, no single country or even group of countries can hope to manipulate exchange rates.  Experience and history shows, in markets where volatility grows, speculators are attracted, further increasing volatility and ultimately creating a ‘doom loop’ – a market crash when all the market players think a major currency is heading down, and all race for the exits screaming “fire”, dumping the currency in a market with few buyers.   As the G20 leaders meet on an isolated island in the Han River, near Seoul, Korea, they will enjoy caviar and roast duck – but will for certain not address the key issue of how the global system can survive without a stable global money, and how the looming unstable forex market can be brought under control, before it is too late.
  2. American President Obama is about to lose some 50 seats in the House, the biggest loss in a mid-term election since Bill Clinton lost about 52 in the 1994 mid-term election.   As his advisors tell him to slash budget deficits, America’s fiscal policy arm is neutralized.  That leaves only monetary policy. But short term interest rates are rock bottom.  So what can be done?  The already near-zero short term rates have not been effective in pulling down long term rates much.  Then, why not try to lower long-term rates? But how?  Well, by massive purchases of bonds by the Fed, which raises their price and lowers their yield.  This is called quantitative easing.  Problem is, the massive amounts of dollars spilling out of the Fed are finding their way to emerging markets’ capital markets, lowering long-term rates in Indonesia and elsewhere in Asia, rather than in the U.S.  The yield on a 10-year Indonesian sovereign bond is only one per cent above that of a U.S. 10-year bond, notes James Mackintosh, FT columnist.  True, Indonesia’s economy is doing well. But – is that a realistic risk premium, 1 per cent?  And if quantitative easing does not work, and fails to stimulate consumer spending and investment in the U.S., what is Plan B? 
  3. Credit default swaps almost destroyed the world.  AIG and other financial institutions sold CDS ‘insurance’, at around 2 per cent premiums, and when the assets they insured collapsed and they had to pay up,  bankruptcy was inevitable.  That bad movie shows some signs of returning.  According to the LEX column in FT, the CDS spread (i.e. the insurance premium rate) on Brazilian and Mexican sovereign bonds is now only about one per cent.  If you have one dollar, you can place a bet that $100 worth of Brazilian or Mexican bonds will be in default.  In other words, the market is saying that if we live for 100 years, only in one of those 100 years will Mexico or Brazil be forced to default.  Really?   Something is radically wrong with risk assessment systems in global capital markets.  We knew that during the 2007-9 crisis, and it is clear today that risk assessment has not been substantially changed or improved.   

There is a simple solution to these scary scenarios.   Stop reading the Financial Times.  We can then live in blissful ignorance, and when the next crash comes, at least we will have slept well before it happens. 


Blog entries written by Prof. Shlomo Maital

Shlomo Maital
October 2010
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