Jackson Hole and the Great Risk-off

August 26, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE — The best reason to sell risk assets is perhaps that the best reason to buy them in are hopes for what one man will say on Friday in a mountain resort.

Federal Reserve Chairman Ben Bernanke’s much anticipated speech at the Jackson Hole economics conference is the subject of fervent wish-casting by investors hoping for another dose of central bank adrenaline, either in the form of more asset purchases, a move to entice banks to lend, or possibly a change in the composition of the bonds the central bank already owns.

Relief measures may be offered, and a rally of risky assets will ensue, but even if they do, Bernanke faces one really powerful opposing force: a wall of money coming the other direction in the aftermath of the credit downgrade of the U.S.

Since the U.S. lost its AAA rating on Aug. 6, 10-year bond yields have tumbled, falling below 2 percent for the first time in history at one point, and even now at an extremely low 2.25 percent. The fall actually began in the weeks before the downgrade, and was in part driven by anticipation of it.

To be clear, falling bond yields also reflect deteriorating economic fundamentals, but much of the momentum has been and will be driven by the profound shock that the loss of the U.S. AAA rating, or risk-free status, has dealt the global financial system.

“This is precisely the reason why U.S. government bond yields have dropped so much in recent months,” Jochen Felsenheimer of Munich-based asset management company Assenagon wrote to clients.

“And not, as officials would have us believe, because most investors see U.S. government bonds as a safe haven. The exact opposite is actually the case.”

This is the great risk-off trade, a huge flow of funds out of riskier instruments like shares back into government bonds, as investors newly alive to the possibility of sovereign default seek to recalibrate the overall risk/reward balance of their portfolios.

While lower Treasury yields make it easier for the U.S. to finance itself, and theoretically should make riskier investments more attractive, the fact that the money is coming out of stocks means that confidence and balance sheets makes this particular drop in interest rates far from stimulative.

MUCH DEPENDS ON A RISK-FREE RATE

To understand why this may be so powerful, it is important to know just how central the concept of the U.S. as a risk free borrower was to the global financial system. This idea, that there exists a risk-free rate against which investors can measure every kind of risk, underpins how central banks work, how the banking system functions and how a huge number of portfolios are constructed.

The widely-used Capital Asset Pricing Model (CAPM), pioneered by Nobel economics laureate William Sharpe, uses the existence of the risk-free rate as a key input to allow the measurement of how much return investors should demand from a given instrument given their objectives.

Risk taking, such as buying a share or making a loan to a company, is, under CAPM, predicated on the existence of risk-free Treasuries, which can serve as a kind of ballast to portfolios. If investors think Treasuries may actually carry a small but real chance of defaulting they will react, at least at first, by selling riskier investments and buying more Treasuries as a means of bringing their overall investment closer to their risk tolerance.

Similarly asset liability management as practiced by insurance companies depends on there being risk-free investments that can help them manage their risks. Since the very purpose of an insurance company is to maintain enough capital to meet obligations, suddenly introducing the idea that Treasuries actually represent credit risk is earth shaking. Rather than simply worrying about the risk that interest rates might rise or fall, insurance companies will be worrying about getting their money back. Again, the knee-jerk reaction should be to sell risk assets and buy the safest ones around, ironically Treasuries.

The other implication of all of this is that as the world’s investors take on less risk in their investments they accept less return, raising problems for pension saving and also very probably acting as a brake on overall economic growth.
It must be very tempting to Bernanke and the Federal Reserve to look at this great risk-off trade and think they hold the solution, to take some new radical step to flush money out of comparative safety and back into the risk markets.

Unfortunately, confidence in the sovereign credit of the U.S. and confidence in the Fed must be closely intertwined. Each succeeding intervention by the Fed has had seemingly less effect, and for a shorter period of time.

If there is a risk rally on Friday, let’s see how long it lasts.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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