Everybody’s focus is on the meeting of G20 finance ministers and central bank governors in Shanghai later on this month
Photo: Film Stills
Financial bubbles are inescapable and their pathologies nearly the same. The only variable is timing. This is why financial crises look so noticeable in hindsight yet remain frustratingly difficult to foresee.
A few years ago, the hedge fund Winton Capital created a handsome and richly-illustrated publication called The Pit and the Pendulum, chronicling many, but by no means all, of the financial crises throughout history.
Winton makes its money by utilizing sophisticated mathematical models to discover when assets are mispriced. It should not work, in accordance with the efficient market hypothesis, which posits that current prices fully and accurately reflect all available data. But David Harding, the founder and chief executive of Winton Capital, believes the hypothesis is bunkum. He lately told a conference that if markets are reliable, he must be either “a lucky monkey or a fraudster”, adding that “neither of those characterisations appeals”.
Markets are, Harding argues, human constructs. As a result, they are target to every human foible. His in depth log of speculative mania and panics was designed to hammer home the point.
The publication incorporates well-known bubbles, such as the tulip mania that gripped 17th century Holland, and the boom in US subprime lending which resulted in the 2008 financial crisis.
Along the way, it journeys from the wilds of Qajar Persia to the bazaars of Constantinople, and highlights little-known bubbles such as the Japanese rabbit mania of 1873, during which fluffy bunnies imported from Europe could bring up to ¥600, at a time when the average monthly earnings was about ¥0.6. (Unsurprisingly those with yellow ears were specifically highly valued.)
The same thing took place with diving patents in the 17th century (which were allegedly going to be utilized to salvage sunken Spanish gold in the Caribbean); Brazilian rubber in the 18th century; and Spanish merino sheep, mulberry trees and British railway securities in the 19th century. And so on and so on: history stuck on repeat.
Such financial crises are likely to happen every 2 to 3 years on average, as outlined by Danske Bank, which helpfully shows that the last one, the European sovereign debt crisis, was over more than 3 years ago. The design is always the same. Cheap money floods the financial system. In 19th century Japan it was compensation payments made to samurai who were disbanded in the wake of the Meiji Revolution. Since 2008 it has the been the 637 individual interest rate cuts perpetrated by global central banks and their matched purchase of more than $12 trillion in assets, based on Bank of America Merrill Lynch.
That capital flows into the less risky assets and pushes their yield (which moves inversely to price) down. Investors get greedy and start hunting at riskier assets. They also start borrowing money to make these investments. This drags in the banks. Leverage builds up. Bubbles start to inflate.
So where might this presently be taking place? Where to start? Emerging market debt is a good candidate, as are US high-yield bonds. The Chinese construction bubble has arguably actually burst and dragged global commodity prices down. But we have still got London house prices, government bonds, energy and commodity companies (especially US shale producers) and additional Tier 1 securities granted by banks, to name but a few steamy assets.
Is the London housing market a bubble?
Sooner or later, money will become less cheap and the method will go into reverse. This is why the financial world is hanging on every word that the chairman of the US Federal Reserve, Janet Yellen, utters. It is also the explanation behind the current obsession with the usefulness of negative interest rates in certain parts of the world.
In Denmark and Switzerland, banks have to pay to place money on deposit with their central banks. Some are passing this on to customers by, for example, increasing mortgage rates. And why is that significant? It means that central bank monetary policy decisions that have been created to stimulate the economy are in fact resulting in a tightening of credit. This is, obviously, far from great. It could be among the first, faint indications that the world’s central banks are running out of room for manoeuvre.
Are we close to the vital point in every crisis – sometimes known as the Minsky moment – when overconfidence flips over into panic? This is what causes markets to crash, banks to begin withdrawing credit and economies to dive into recession.
Switzerland has introduced negative interest rates
Emotion plays a critical role, because markets are not reliable. Jeffrey Currie, the senior commodity analyst at Goldman Sachs, put out a notice on Monday which argued that the markets had “nothing to fear but fear itself”. But that is not so comforting, because fear looks to be taking hold. Gold has risen by more than 14pc this year; Bank of America’s latest fund manager survey discovered that investors have a bigger percentage of their portfolios invested in cash than at any time since 2001.
Maybe the admittedly benign economic fundamentals outweigh the financial dislocations. But add to the latter a palpable sense of fear and the balance starts to tip.
The next G20 meeting will be held on February 26 and 27
That is why everybody’s focus is on the meeting of G20 finance ministers and central bank governors in Shanghai later on this month, appropriately enough, on February 26 and 27.
Bubbles consistently burst. But some grow a little larger and float a touch longer on the breeze before they do. The question, thus, is not “if” but “when”. One wrong action by the world’s central banks and that could be sooner rather than later.