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Crisis indicator flashes red
One obscure market early warning sign is flashing red. Matthew Partridge explains what it is, and asks should we be worried?
Since the financial crisis in 2008 there has been a bit of a boom in the market for "early warning signs" obscure indicators that might flag up that we're heading for trouble again. One such indicator is flashing warning signs right now. The alert in question relates to a feature of the currency markets known as covered-interest parity. In the currency markets you can buy a currency (buy the dollar versus the pound, say) at today's rate (the spot market) or on a future date (the forward market). Covered-interest parity states that the gap between the two prices should equal the interest-rate differential between the nations involved.
In other words, if the US dollar pays an interest rate of 5%, but sterling yields only 3%, then the futures market should price in the dollar falling in value versus the pound. If this doesn't hold, then theoretically a trader could lock in a guaranteed profit by buying dollars with pounds in the spot market, earning the interest, and selling dollars in the futures market to cover their position. Any gap would thus be arbitraged away.
Yet covered-interest parity has broken down, following the surge in the US dollar that came after Donald Trump's election in November. "In short," says Sid Verma on Bloomberg, "investors in the yen and euro seeking to hedge their dollar obligations are now forced to pay an effective Trump premium." What worries some observers is that the same happened in 2008 and during the 2011 eurozone crisis. So should we be worried? As The Economist notes, the Bank for International Settlements, the "central bank for central banks", reckons there are two factors at play.
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Rising demand among overseas investors for US dollars (at least partly driven by expectations that Federal Reserve policy will become more aggressive under President Trump) is one contributing factor. In itself, this is not a warning sign of a pending crisis. In 2008 and 2011, demand for dollars soared because investors were seeking safety. Right now, there's a more benign reason dollars are in demand hopes for strong US growth.
However, the fact that the disparity exists at all is more worrying on a "financial plumbing" level. Banks or traders financed by banks should have spotted this opportunity and arbitraged it away. But as Buttonwood in The Economist points out, the other factor identified by the BIS is that the "banks are unable to provide the same levels of liquidity as they did in the past". That's not necessarily a bad thing in itself (it also means that banks are not taking quite the same risks), but it does mean that when the next crisis does actually erupt, we may find that "markets freeze even more quickly than before".
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