Havens are safe ... until they’re unsafe
In global capital markets a “flight to quality” was traditionally regarded as a change of sentiment, where investors tried to minimise the risk of a loss of principal rather than chasing high returns. That normally meant retreating into government bonds yielding a safe income. US treasuries were seen as the ultimate bolt hole.
Yet the flight to quality that came and went with the American killing of Iranian military commander Qassem Soleimani did not square with that description. Investors who fled into the Swiss franc or Japanese yen, both long-standing havens, were exposing themselves to negative interest rates. To call this “quality” borders on the oxymoronic given that holding Swiss franc or yen government bonds to maturity would guarantee a loss of principal.
In reality, though, flights to quality have never been exclusively about trying to avoid capital loss, because another favourite refuge in geopolitical, economic or financial crises is gold — a purely speculative asset yielding no income. Any dollar-based investor who bought the yellow metal in a funk at the time of the second oil crisis in 1980 would have sustained heavy immediate losses, and would have to wait more than two-and-a-half decades before their investment was back in the black.
Gold was also a terrible protection against the eurozone debt crisis. Investors who bought gold as a hedge before the Greek government’s partial default on its debts in March 2012 would have been showing persistent mark-to-market losses in euro terms until late last year.
That makes it all the more surprising that bitcoin surged on the Soleimani killing, prompting market talk of a new “crypto gold”. For bitcoin is even more volatile and unpredictable than the yellow metal. While it is independent, decentralised and not under governmental control, which some see as important advantages, it satisfies very poorly the traditional criteria that define money, namely being a unit of account, a medium of exchange and a store of value. And it lacks the trust that is generated for conventional money through independent and accountable central banks. Nor is there the regulatory apparatus, supervision and deposit insurance that are provided for conventional money by the state.
As Bank for International Settlements research head Hyun Song Shin has pointed out, trust in bitcoin can evaporate at any time because of the fragility of the decentralised consensus through which transactions are recorded. This means a cryptocurrency can simply stop functioning, resulting in a complete loss of value.
Returning to old-fashioned securities, it is clear that flights to quality and liquidity are different in the context of post-crisis, ultra-loose monetary policy. For a start, because of the yield compression brought about by central banks’ asset buying programmes, the flight is much shorter than in the past. By the same token, investors buying into havens need to recognise that they are fighting the central banks, whose quantitative easing was designed precisely to push investors to take on more risk. That is not a policy that invariably ends well.
At the same time, the central banks’ own buying of government bonds causes a shrinking supply of paper, leading to an increased liquidity premium in bond prices — and vice versa when they stop buying or start selling. Dimitri Vayanos of the London School of Economics points out that such a liquidity premium is also affected by the behaviour of fund managers who may suffer withdrawals of funds if they underperform, as often happens in periods of heightened volatility. That vulnerability reduces managers’ willingness to hold illiquid assets and raises liquidity premia.
The extreme example of such behaviour came in 2007-2008, when the problem became chronic. Even money market funds were regarded by investors as unsafe. The resulting flight to quality caused treasury yields to collapse and created severe disruption in credit markets and other parts of the financial system. At the same time, gold and oil saw record spikes. Because of the dollar’s role as the world’s pre-eminent reserve currency and the centrality of Wall Street in the global financial system, the flight to quality was magnified by huge capital inflows.
These days, though, the allure of treasuries is dimmed by the paltry yields they offer, by historical standards. It is not surprising, then, that investors now appear to see the “Faangs” — Facebook, Apple, Amazon, Netflix and Google (whose parent is Alphabet) — as more attractive havens thanks to their cash-generating capacity, rich balance sheets and deep liquidity in the marketplace. All bar Amazon are up sharply this year, having already rallied strongly in 2019.
There could be no better indication of how ultra-loose monetary policy has turned long-standing conventions of the financial world upside down than when equity comes to be seen as a natural repository for nervous money.
© The Financial Times 2020