The structural hegemony oil-producing countries have enjoyed for the last 70 years was suddenly abandoned at an afternoon press conference in Riyadh, and the Swiss (the Swiss!) suddenly abandoned their dollar peg and the entire country re-prices 30% overnight. Believe it or not, all of this happened in 2015 and 2016 is already looking a bit scarier, with serious implications for the path of U.S. rate policy.
South America is no stranger to sovereign defaults. Reinhart and Rogoff’s popularized phrase “extend and pretend” forms the basis of most sovereign debt defaults. The “this time is different” mentality commonly frames historical events, especially those of an economic nature, as endemic to conditions that exist at that time. Unfortunately, that will not be the case for Brazil in 2016 and the systemic shock could be significant.
Where we stand now is a global commodity complex that has been wiped out with oil forwards pricing in stability, but not a rebound. (Explain how to create a synthetic commodity position, and use it to explain the relationship between the forward price and the expected future spot price. Commodity Forwards and Futures [FMP–12]). The core index of commodity prices supporting Brazil’s economy—oil, iron and soybeans—has fallen over 40% since 2010. Not only are commodity prices troublesome, but the Baltic Dry Index, the leading indicator of shipping demand, has fallen through the worst levels we say in 2008. Now, there is clearly a shipping container glut but there is clearly a demand side problem as well.
Although it is rare that any market will realize forward prices, (identify the most common assumptions in carry roll-down scenarios, including realized forwards, unchanged term structure, and unchanged yields. One-Factor Risk Metrics and Hedges [VRM–10]), the supply dynamics and anemic future global growth don’t bode well for a strong rebound to oil either. In two short years, Brazil’s economy has shrunk 8% and GDP per person is down a full fifth since 2010. (Explain how a country’s position in the economic growth life cycle, political risk, legal risk, and economic structure affect its risk exposure, “Country Risk: Determinants, Measures and Implications” [VRM-12])
Not only are revenues down, but Brazil’s constitution also offers a rare inflation protection so that the purchasing power of all benefits is carved in stone. Runaway pension costs are one of the single greatest contributors to sovereign defaults over the last 40 years and Brazil seems to be creeping closer to that precipice. (Describe factors that influence the level of sovereign default risk; “Country Risk: Determinants, Measures and Implications – The 2015 Edition”. [VRM-12]) The constitutionally protected pensions and pension cost-of-living increase riders now cost over 10% of GDP, which already exceeds the much older (and richer) Japan. As a proportion of it’s wealth, Brazil’s public debt is already twice that of Greece.
How has Brazil’s central bank responded? Despite three rate hikes in just over a year—to a mind-boggling 14.25%–the local currency continues to depreciate. (Compare instances of sovereign default in both foreign currency debt and local currency debt, and explain common causes of sovereign defaults. – [VRM-12]). The really disconcerting element of this witches’ brew is the monetary policy tool of raising rates to stabilize the currency but would also signal to the market a default is increasingly likely. (Describe challenges and constraints to a central bank acting as a lender of last resort. “Why do we need both liquidity regulations and a lender of last resort? A perspective from Federal Reserve lending during the 2007-09 U.S. financial crisis”. Federal Reserve Board. February 2015.* [CI – 3]) A market signal of sovereign default would only cause investors to dump bonds and push rates higher.
There is one saving grace for Brazil: Most of the borrowing is in local currency which means it can print its own interest payments, but does so at the risk of the very inflation it is trying to tame. For now, in a world hungry for returns, investors seem to be willing to take the risk and less worried about a sovereign default relative to other risks in an increasingly volatile world. This is especially true given Brazil’s significant dollar income based on oil, albeit at depressed prices, and the prudent use of foreign exchange swaps by the central bank to remove exposure from the Real falling further. (Explain how a financial institution could alter its net position exposure to reduce foreign exchange risk. Foreign Exchange Risk [FMP-13])
Unfortunately, the troubles for the “B” in “BRIC” is only the tip of the iceberg. Russia’s troubles are well known with falling commodity prices. China’s mammoth policy response to the US crisis of 2008 that was straight out of Rogoff and Reinhart’s “extend and pretend” playbook has left that country with a New Year’s hangover of bad debt, anemic growth, and the very real potential for devaluation of the Yuan in 2016. (Calculate the potential gain or loss from a foreign currency denominated investment. Foreign Exchange Risk [FMP-13] )
All these factors have created an island of stability around the U.S. dollar, which has already moved that currency into overbought territory, making U.S. goods less competitive globally and creating employment headwinds. It is very possible the United States will see a world in which the commodity complex continues to get crushed under non-existent growth and, as investors hit the exits of risky trades in return for stability, watch the dollar rally even as employment declines, inflation is non-existent, and The Fed has to make the argument to continue to hike rates. A tall order at best.
It is too early to buy your “one and done” rate hike T-shirts just yet, but this complex witches’ brew of competing interests will create a unique mosaic of conflicting signals about where to find growth and how to avoid the risks in the tails. This type of tension among so many competing factors tends to function smoothly until it suddenly doesn’t (Compare the shape of the volatility smile (or skew) to the shape of the implied distribution of the underlying asset price and to the pricing of options on the underlying asset. Volatility Smiles [MR–17]) but, at the same time, does create opportunity if you know where to look.
The FRM designation is not for risk managers. It is for people who are genuinely curious about the moving parts of the world and how to create a mosaic of your own from so many seemingly unrelated threads. 2016 is going to be a very interesting year. Join me in adding the FRM program to your New Year’s resolution list and make it a little less mysterious.