Monday, August 15, 2011

The Quest for Safe Havens

Equity markets around the world have plummeted in the last few weeks. The downgrade of the US sovereign debt has dented market sentiment, and the quest for safe haven assets has begun. The US Federal Reserve has pledged to maintain the benchmark interest rates at near zero levels for another two years, hoping that lower interest rates would help revive the economy. Problems for the Euro-zone seem to have worsened in the last twelve months. The PMI readings across the emerging markets have dropped. There is a sense of uncertainty across the global markets.
The drop in appetite for riskier assets due to poor macro-economic data across the global economies has boosted demand for risk free assets. The yield movement in the 30 year US bond highlights this fact very much. Despite a credit downgrade, the bond prices rallied to record highs. This probably highlights the fact that despite the downgrade, the greenback seems to have retained its safe haven status. The US Treasury continues to maintain lower risk weights on the US bonds, thereby providing respite to the US banks. A US default is technically impossible, but it is practically difficult to digest the fact that, a country is enjoying a fall in its borrowing costs, despite its credit rating getting lowered. Rising global uncertainties have given birth to events that seem to defy common logic. Macroeconomic indicators from the US too have not been great. The first quarter GDP was revised significantly lower to 0.4%, while the growth rate for the second quarter stood at a dismal 1.4%. The growth rates should fall further as the QE 2 ended in July. The recent agreement to lower the country’s debt too should hamper growth. Bank of New York Mellon Corp. is planning to charge a fee for holding cash in accounts. Such unseen events are due to maintaining near zero interest rates for a prolonged period of time. Economic stimulus probably has helped the US banks to improve asset quality, but now that there has been an improvement in asset quality, the question that needs to answering is: How are these huge financial institutions going to grow in a stagnating economy?
Meanwhile, in the Euro-zone economic indicators are pointing towards weakening of the region’s economy. French GDP stagnated in the second quarter. Greek GDP recorded a steep drop in the previous quarter. There has been a contraction in the manufacturing output in July, which indicates that manufacturing, which occupies a major portion of the European economy, has probably slipped into recession. Countries are being forced into austerity measures to get their debt refinanced. The Spanish and Italian bond yields rose to record highs, prior to the ECB’s intervention in the bond markets. However, such actions would be temporary. The European Union leaders have to raise the EFSF to tackle this crisis. Currently the total funds in the EFSF stand at €440 billion. Inclusion of Italy and Spain to the EFSF should probably lead to the fund crossing the trillion dollar mark. Such an action could probably lead to a downgrade in the German and French credit rating. Many of the European banks have posted weak earnings in the current quarter. The fall in profits, was mainly due to provisioning in Greek debt. The central bank and the EU have not provided any concrete solutions to tackle the rise in toxic assets in the balance sheets.
It is clearly evident that both the US and Euro-zone economies are facing plenty of problems, that could eventually lead to the derailment of global economic growth. 85%-90% of the global reserves are held in form of US or Euro-zone assets. Such never-seen-before events have led to the outflow of liquidity into safe haven assets such as the yen, Swiss franc and gold. Low bond yield on Japanese bonds, enables the government to raise funds at lower interest rates. The Japanese economy has been facing many problems in the last few decades. Rising capital inflows should further cripple growth, since it is more of an export led economy.
Crude oil and base metal prices tumbled, amid concerns over slowdown in the global economy. Inflation has reached record highs in China, and declining growth in the Western areas should only contribute to the fall in the commodity prices.
The only safe haven asset that seems to be performing well is gold. It is the only safe haven asset which has a zero default risk. Gold has always performed well in times, when the world faced threats due to rising prices. Gold has been seen as a great hedge against inflation, but with commodity prices tumbling, the yellow metal has not provided any signs of cooling down. Markets seem to believe that holding precious metals in times of such uncertain environment should provide protection of wealth. There has been a steady rise in gold reserves across the world. Sovereign debt concerns seems to have spurred demand for the precious metal. Central banks in Korea, Mexico, Thailand and Russia have reported a steep rise in gold reserves in the last twelve months. Would the weakening greenback and rising global uncertainties force the world to return to gold standards?


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