Why don’t foreign investors get scared more often?

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BACK in the days of the gold standard, central bankers were very concerned about the attitudes of international investors. They believed that maintaining the value of their currencies would reassure creditors. That is why they were so against the idea of ​​floating currencies. Georges Bonnet, the French finance minister, put it best

Who would be willing to take a loan for fear of being paid in depreciating currencies always before his eyes?

This fear still appears from time to time. Under the old exchange rate mechanism, countries like Italy would go through periodic devaluations to restore their competitiveness*. As a result, investors would demand a higher bond yield to compensate for this risk. When the single currency was designed, bond yields slowly fell at the German level as the risk of deflation disappeared. It reappeared in 2011 and 2012 as investors feared that some countries might drop out of the euro and repatriate domestic currencies; that would have required partial presetting. (Of course, Greece stayed in the euro but its debt was restructured.)

To a large extent, however, in the developed markets, it seems that foreign investors accept a very low yield, despite the risks of losing money. In the run-up to the Brexit referendum, gilt investors were getting returns of just over 1%. When the Leave side won, the pound immediately fell about 10% against the dollar, wiping out many years of bond income. At the moment it is not entirely clear whether the administration of President Donald Trump wants a weak dollar, but if his priority is to eliminate the trade deficit, a shrinking greenback seems necessary. But at 2.7% the yield on the ten-year Treasury offers little compensation for currency risk.

The “smart” response to this situation is that today’s investors are more sophisticated and separate investment decisions and money; they are simply hedging against a declining dollar. But it is not a very satisfactory answer. Someone has to take the other side of the fence. In the short term, that might be an investment bank. But banks don’t want to be too close to a declining dollar. They try to load the risk. Overall, the market cannot cover itself; someone else has to take the trade and what’s in it for them?

A better argument might be that investors cannot know which way money will move. In the old days of fixed exchange rates, they had a one-way bet; it was highly unlikely that troubled countries would revalue their currencies but they could depreciate. Often, domestic investors were the ones who panicked, moving their money out of the country to avoid a downturn; bond yields would have to rise to fill the hole they left. Today, it is very difficult to predict currency movements based on fundamentals. Many thought that the dollar would go down once the Fed started using quantitative easing (QE) but the other big central banks came to QE as well. The dollar may have weakened in the past year but the market trend may change again. As a result of this uncertainty, international investors will choose a portfolio of government bonds from different countries, expecting to recover what they lose on the money movements on the roundabouts.

The most convincing argument, in my opinion, is that many bond investors do not maximize profits; they own their links for different reasons. Central banks can have Treasury bonds as a way to manage their cash reserves, for example; pension funds and insurance companies may own them to match liabilities or for regulatory purposes. So they are very averse to currency or indeed risk taking. The kind of investors who have scared off central banks and governments in the past – the bond market watchers of the 1980s and 1990s – are only a small subset of the whole.

* Loss of competitiveness was usually the result of higher inflation, so countries with high inflation were expected to see their currencies depreciate. This also meant they had higher short-term interest rates. An old financial law was “covered interest parity”. If country A has 12-month rates of 10% and country B rates of 5%, the former’s currency trades at a 5% discount on the forward market. Otherwise, free money would be available to those who invest in country A and lose their money.

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