Search for yield blinds markets to real political risks


One possible argument is that investors have taken Lord Nathan Rothschild’s dictum that “one must buy to the sound of cannons, sell to the sound of trumpets” to heart. However, the evidence is mixed as to whether this has proved a particularly wise long-term investment strategy. The declines seen in the Dow Jones Industrial Average after the US entered both the first and second world wars, the drops seen at the start of the Korean war, the early days of the Cuban missile crisis and in the immediate aftermath of the invasion of Kuwait in 1991, would all suggest caution.

A stronger argument is that this is an example of the phenomenon that Raghuram Rajan helped identify during his time as the chief economist of the International Monetary Fund as “reaching for yield”*. The argument is simple enough: in an environment of low yields investors shift towards riskier investments in search of higher returns. This search for yield often also leads to what appear on the surface to be benign trading conditions as investors use any dip in prices to squeeze as much additional yield as they can out of the market.

As market volatility declines, investors become more convinced that this is a benign environment and therefore become even more willing to use market dips to build positions. Should the low yield environment continue for an extended period of time, then the temptation to take excessive risk will grow.

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As a paper published by the Federal Reserve Bank of Richmond in 2013 noted, “the evidence of reaching for yield is hard to come by”. Nevertheless, the pattern of declining volatility in markets matching to periods of ultra-easy monetary policy appears well established since the Federal Open Market Committee under the leadership of Alan Greenspan took its target rate for federal funds down to 1 per cent in 2003.

On the face of it, this might appear a curious explanation for what is happening right now. The Federal Reserve has, after all, raised its target rate three times over the past nine months (following an initial move at the end of 2015). However, it makes more sense when the actions of other major central banks are taken into consideration.

The European Central Bank continues to run the interest rate on its deposit rate at -0.4 per cent and make net asset purchases of €60bn every month. Meanwhile, the Bank of Japan still applies an interest rate of -0.1 per cent to the policy rate balances in current accounts held by financial institutions at the bank, while also purchasing Japanese government bonds. Elsewhere, the Swiss National Bank, Danmarks and the Sveriges Riksbank have equally remarkable policy settings.

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