Keeping in mind our discussion in parts 1 & 2 and the apparent benign view of low interest rates taken by the US monetary authorities, what specifically must risk managers do to be better prepared for the decade of Black Swans? It is our opinion that the focus of risk is now in the sovereign area and multiple partial defaults by inflation are likely worldwide. The uncertainty surrounding these events is very high, but, as we argued time and again, risk management is not about estimating specific sequence of events or their timing, but rather about identifying instability potential and dangerous trends and being prepared with contingency plans.
Some Implications for a Risk Management Process
1. Risk managers must implement stress tests shocking longer term interest rates by 400-500 bp in the US. This rise as not a Black Swan (which is unexpected), it is a virtual certainty, though the timing, of course, is not known (it could take months or years). Even the Fed itself strongly urged such stress tests (though I cannot now find the link with their memo to the banks with that suggestion).
2. Now more than ever, firms must avoid taking risks that they do not fully comprehend (and do not have a plan for hedging out quickly). Currency volatility is going to be very high even in the absence of any extreme events. Avoiding unknown currency exposure, hedging, stress testing of currency rates are all very necessary.
3. Extreme risk cannot be diversified away, it can only be hedged (especially since the counterparty risk is lower due to governments' belated realization that systemic financial institutions cannot be allowed to fail).
4. Those that invest in the emerging markets in hopes of diversifying US exposure will again learn that under conditions of global mobility of capital this supposed decoupling will provide about as much protection as an umbrella from a nuclear strike. However, the equity and housing markets in the US will likely be supported by the Fed until it is no longer able to do so and this will provide a sort of "Bernanke put". This doesn't mean that there is no downside in those markets, it just means that Fed will do its best to put some support level underneath them with liquidity injections.
5. Risk managers have to watch for signs of large scale monetization of US debt. Once it starts, there is a possibility that the events will move very swiftly. One way to follow it is to watch the Fed's custody account growth which will indicate how much the foreigners are really buying (The Martenson Report gives a very solid analysis of the numbers). Another perspective on the magnitude of the debt problem is to look at what would have to be done to reduce it to a manageable level (and even those projections are far far too rosy).
6. Every risk manager must become an expert on China, because they hold the key to how the events will unfold in the short to medium term (the long run consequences are pretty unavoidable at this point). This is not because their economy is in perfect shape (they will have a difficult time adjusting to a less of an export economy in this environment), but in the current situation it is their decision on whether to continue to be a financing supplier of the low cost consumer goods to the US is the linchpin on which the whole precarious structure hangs (absent major external shocks as mentioned above). For example, if China decides to revalue their currency upward, due to the rising inflation, as the US monetary policy spills over to China, this could signal the start of the inflation in the US in earnest. Success of US pressure to revalue the yuan upward would have a similar effect.
6. There are very few true hedges against these sovereign partial default by inflation scenarios (as there are few true hedges to anything). Oil, gold and commodities appear to be the only reasonable long term hedges at the cost of high intermediate volatility (disclaimer: authors do own gold and derivatives on it since November 2008). Risk managers would do well to watch the events and make appropriate decisions on hedging if the situation clearly worsens. This might be the reason such astute speculators as George Soros and John Paulson are loading up on gold (while talking it down in the case of Soros).
It is frequently said that the generals are prone to fighting the last war. Similarly, the world monetary authorities are still fighting the liquidity crisis, when there is really a worldwide solvency crisis looming. The coming decade can make 2000's seem calm by comparison.