Risk Free?

"The biggest risk is not taking any risk.  In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking any risks." - Mark Zuckerberg

If you had taken a wander into the deepest darkest jungles of Brazil for the past seven months and had suddenly emerged it would appear on the surface that nothing had changed in the world of finance.  The rate on the 10-year Treasury was roughly the same as it was at the beginning of the year, the stock market has essentially not budged and looking abroad it is much the same picture on the international scene (other than the Chinese stock market).  You would be forgiven for thinking that everything was moving along in a slow and steady march to prosperity but what the surface reflects is not the case behind the scenes.

Take the German and the US 10 year bonds.  These assets are considered by the financial world to be the two investments considered to be as safe and as risk free as is possible.  The perception is that there is limited to no chance that an investment into either of these assets will ever result in a loss of principle.  The investment therefore is considered risk free.  Tied to this investment is a rate of return or yield and this yield is considered to be the risk free rate.  Any investment made outside of these investments other that shorter or longer termed investments into these government bonds is expected to return something in addition to the risk free rate.  The term for the return in excess of the risk free rate is the risk premium and the risk premium should coincide with the risk of the investment.

As an example if you invest in a high quality corporate bond the risk of default may be low but it will still be more than the government debt so it should yield slightly more.  As you move out on the risk scale to say private equity, the risk of loss increases considerably but so too should the expected payout therefore, the expected return on the investment should be substantially above that of the government bond.  All other investments fall somewhere along the spectrum of risk and return and all are measured against the baseline of the risk free investment.

So one would then consider that the risk free investment, being risk free, should remain relatively stable.  Considering that the central bankers of the world do not adjust the interest rate on the underlying bonds often, the only thing that adjusts the yield on these bonds is the secondary market which trades these bonds after they have been issued.  It is the forces of supply and demand in the secondary market that determine the current yield on the investment and these forces are influenced by the expectations of the market itself.  Even so the market should be relatively comfortable with the security of the investments so they should remain relatively stable with some minor movement here and there.

Looking at the yields on these two assets year to date shows huge fluctuations in the yield of these assets.  The German Bund has gone from a yield of 0.80% at the beginning of the year to a yield of zero before rocketing back to 1.00% and then falling back to its current position of 0.80%.  The 10-year Treasury cratered from 2.20% at the beginning of the year to 1.63% before bouncing around and then jumping up to 2.45% and then gradually coming back to around the 2.20% mark again.  While to the outsider these moves may seem small but percent wise these are enormous moves and throw into question just how safe are these investments?

Now I am not considering for a moment that these investments will not be repaid, they will and so they are safe but what I am pointing out is that the world of investments at present is anything but safe.  There are considerable undercurrents that are bubbling below the surface, the majority of which are being created by the massive "stimulus" policies of the central bankers and this is what is causing the massive swings in a normally complacent market.  Think of it in terms of global warming, as the world heats up there are more and larger environmental consequences beyond the control of humans, the same is happening in the world of investments; as the pot of money sloshing around the financial markets increases daily by billions of dollars in the biggest monetary expansion experiment known to man, so the risks to the financial systems around the world increase exponentially.

In this ever changing world make sure that you keep a close eye on the gyrations in yields in these markets as until they settle down it is clear that there is a lot of risk that is being hidden below the surface.