Political risk back in the spotlight as possible bond default shocks

Arguably the strongest contender to make the biggest waves in financial markets in the second half of this year are negative yields on bonds which have gradually evolved from merely a concerned thought into a desperate situation described only by the panic acquisitions of similar instruments containing positive returns regardless of the risk attached to it that could very well overshadow the scale of catastrophe when compared to the Financial Crisis of 2008/09.

Late in July I wrote a piece about the rapid transmission of funds from bonds markets in the developed world in favour of fixed income securities in emerging markets that offer the very least of a positive yield. The reason being the protracted use of monetary stimulant in the form of negative interest rate policy in countries such as Japan, Switzerland and the European Union in bid to purge economic stagnancy setting in.

At the time I concluded the absence of rationality from investors when considering all risks embedded in an instrument was an alarming notion to contemplate yet the onset of such a view has already infected the current market sentiment with disastrous consequences.

A twig of sensibility should be heeded in the latest reports coming out of Mongolia where newly elected government officials have stated their intentions to avoid default on its country's debt at all costs. This after the Mongolian bond market saw a surge in demand for its fixed income securities from positive yield seekers finding refuge from the financial storm.    

Yield-seekers get reality check as Mongolia sounds alarm on economic crisis @natashadoff https://t.co/8ZPwmBW7SL pic.twitter.com/5iVYZaqBjz

— Emerging Markets (@BloombergEM) August 11, 2016

However they hadn't counted on an outcome such as this to occur which meant it sent shockwaves throughout the Mongolian financial market once it was heard. But surely how can one blame the prudence of government especially in times when austerity is needed? It's nonsensical.

The matter goes straight to back to what's been said earlier; the irrational investors as opposed to the norm of rationality has blurred the outlook of financial markets to such an extent that not all risks have been considered leaving investors vulnerable to being caught in sudden price changing events.

Political risks stemming from emerging markets have grown in frequency due to their interconnectivity with big brother China in reference to trade relations. The contraction of the Chinese economy has not only hardened the view of its citizens but also those who have suffered gravely as a result of a slump in trade with communist reforming nation.

Besides this, the economic outlook has shifted vastly from prosperity to despair translating directly into potential political shockwaves occurring from the dissatisfaction of citizens on its governments which isn't fully being accounted for in terms of risk. Mongolia might be the first but certainly won't be the last offering an inkling of what can progress if the issue of negative interest rate policy isn't addressed with true reflection of its impacts on the rest of the world.

Emerging market bonds experience mass capital inflows

The search for yield continues with the weekly net capital flow into emerging market bonds recording the highest inflow of all time marking a pivotal moment in the scramble to secure positive returns.

Analyst believe the contagion spreading through advanced economies bond markets, which has seen trillions of dollars in face value bonds turn into negative yields at an alarming rate, continuing due to the expectation on its central banks (some of the most respected in the world) to deliver further stimulus after a number of rounds of quantitative easing have left policymakers puzzled and frantic for a solution.      

Everyone wants a piece of the EM bond pie https://t.co/2KOywQ5MYk pic.twitter.com/iImJt8M0qy

— Bloomberg Markets (@markets) July 25, 2016

Reading through the article posted on Bloomberg, the reporters stated:

"With real sovereign yields in emerging markets high, relative to a flattening U.S. yield curve, the data suggests investors are ignoring political risks that have been exposed by events like last week's failed coup in Turkey, even if they're doing so through gritted teeth"  

This raises an important question when referring to the rational investor who is said to consider all risks when choosing the optimum choice of investment that fits his/her risk profile. If investors are deemed to push aside political risk in exchange for return then there's a case of emotional turmoil spilling over into financial markets, lessening the strength of those who propose rational decision making occurring in the normal course of trade.  

All risks aren't being considered directly skewing the picture with market participants urgency to generate income in a market growing excessively out of control. The true reflection of the condition of financial markets can't be taken from the valuation the market places on it but rather from the hesitancy of investors to shake themselves out of "safe haven" assets into riskier ones.