Amid elevated market uncertainty, investors have been clamoring to get their hands on so-called "safe assets," privately and publicly issued securities with little risk used to hedge against more volatile investments.
Of primary focus has been sovereign bonds. U.S. government Treasuries, Japanese government bonds, and German bunds are trading at record highs, yielding little profit for investors.
But the scarcity—and thus the high price of these securities—has been exacerbated by central bank measures taken to mend the troubles of the crisis.
Since the financial crisis, quantitative easing has essentially given banks in the U.S. and U.K fast cash in exchange for Treasuries and gilts, and immediately freed up funds to put money in riskier places that would spur corporate growth.
However now investors are worried that the long-term effects of driving up the cost of safe assets will make it harder for institutional investors like investment banks and hedge funds to meet the stricter standards of new rules put in place to ensure financial stability.
PIMCO's Mohamed El-Erian expressed this anxiety in a speech to the Federal Reserve Bank of St. Louis yesterday. "In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability," he said. " In the case of three institutions in particular (the Bank of England, the Bank of Japan and the Fed), they also change the balance between “safe” and other assets in the financial system."
The International Monetary Fund has seconded this concern. A team of IMF economists led by Silvia Iorgova describe the crux of this problem in a report out this week (pdf):
The shrinking set of assets perceived as safe, now limited to mostly high-quality sovereign debt, coupled with growing demand, can have negative implications for global financial stability. It will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets. Safe asset scarcity could lead to more short-term volatility jumps, herding behavior, and runs on sovereign debt.
Essentially, because there are fewer safe assets, investors are forced to move to riskier assets less agile at hedging their bets if they want to invest at all.
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This behavior has been compounded by recent regulations made to make the financial industry more stable in the long run:
The advent of new regulations may force banks to hold even more safe assets. For example, on the liquidity side, unless banks alter their liability structure to moderate their liquidity needs, the requirements of the new Basel III Liquidity Coverage Ratio (LCR) alone could further increase the demand for safe assets by some $2 trillion to $4 trillion worldwide (see Box 3.4). An increase in the risk weights of riskier sovereigns could also spur stronger demand for the safest sovereign assets (see Box 3.3). In addition, business uncertainty is likely to put upward pressures on such demand.
But is this a bad thing? In the last few years, we've seen a housing bubble turned into a full-scale financial crisis and a financial crisis become a sovereign debt crisis largely because investors miscalculated the risk of their investments when all did not go according to plan. In that sense, the re-pricing of historically safe assets—particularly government debt—to account for risk is an important move towards long-term sustainability.
Further, Economist Paul Krugman argued yesterday that compounding worries about the lack of safe assets are overblown:
Surely the main point is that the major economies seem likely to remain depressed for a long time, and that as a result short-term interest rates are likely to stay low for a long time too — which means that long rates, which largely reflect expected short rates, are low right now...
My point is that the “safe asset” meme seems to imply that there’s some kind of market aberration in the high prices (and low yields) of bonds, that investors are willing to lose money because they’re frightened. But most of what we’re seeing just reflects a perceived lack of good investment opportunities.
On the other hand, the IMF makes the case that the shortage of safe asset opportunities is compounding the very problems that sparked this behavior in the first place. Sustained high prices of safe assets backfire on the impetus for QE in the first place, restricting rather than expanding investment:
Considerable upward pressures on the demand for safe assets at a time of declining supply entails sizable risks for global financial stability. The unmet demand drives up the price of safety, with the safest assets affected first. In their search for safety, investors that are unable to pay the higher prices are likely to settle for assets that embed higher risks than desired...Such frictions in funding markets can reduce the ability of financial institutions—including investment banks, asset managers, and hedge funds—to secure funding or onlend excess funds.
This funding pressure carries over to sovereigns that are not as creditworthy as others, increasing opportunities for disruptive shocks. This is of particular concern in Europe right now. Once again, from the IMF:
Banking sector stress can create higher contingent liabilities for the sovereign sector or the need for outright government support. If risk weights suddenly increase, banks may be prompted to deleverage by curbing new lending, leading to a dampening effect on economic growth, and to secondary effects on sovereigns via weaker tax revenues. Ultimately, this could exacerbate negative feedback loops between sovereigns and the banking sector, as has been observed in parts of Europe in recent months.
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Obviously, this does not paint a rosy picture. According to the IMF, the only successful method of alleviating this problem has been high liquidity, but central bank measures to do this provide diminishing return, as we can see with the decreasing effect of successive rounds of Fed QE on the markets.
But is this a "market aberration"? Is the shortage of safe assets generating a problem that the market will struggle to correct?
In a blog entry yesterday, Brad DeLong argues that all the signs point to a bigger problem than a simple shortage of good investment opportunities, suggesting that the problem is self-reinforcing:
Equities do not seem to be selling at extraordinarily high earnings multiples now--which is what we would expect to see if the root problem were just a shortage of good investment opportunities. When there is a shortage of good investment opportunities--an excess demand for savings vehicles, ex ante full-employment savings greater than ex-ante full-employment investment in the Wicksellian-Keynesian-Hicksian framework--interest rates and earnings yields tend to all be unusually low. Today it is just interest rates on assets perceived as safe that are unusually low. And boy are they unusually low!
While asset re-pricing is desirable in the long run, the IMF argues, in the short run institutions must be careful not to move too fast on sustainability regulations that would limit bank lending. Meanwhile, El-Erian argues that central banks should be careful not to exacerbate the safe asset shortage through more QE.
We see the case for concerns about safe assets, but their direct effect on funding pressures and the slow recovery remains unclear. There are plenty of reasons to be cautious about investing right now—Europe, oil, China, to name a few—even while U.S. corporates and the U.S. economy look to be on a stronger path to recovery, so the distinct effect of a safe asset shortage is hard to measure.
Either way, this does seem like the best argument against central bank action and quick implementation of financial regulation that we've seen yet.
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