The astonishing political disappearance of British Prime Minister Liz Truss shows what can happen when ambitious plans collide with a new financial market reality that puts the fight against inflation above all else.
Truss’ implosion was fueled by quintessentially British considerations. But the market turmoil – which at one point saw investors judging Britain as a worse credit risk than notoriously profligate Italy – sparked unexpected difficulties in UK pension funds and launched a search for the next financial domino that could tip as interest rates rise.
Bond mutual funds, pensions, corporate debt and public finances are all being scrutinized for hidden weak spots, analysts said, as the Federal Reserve continues to raise interest rates at the pace fastest in 40 years. Investors expect the central bank to hike rates several times over the next few months in a bid to calm rising consumer prices, including at its next meeting in November.
“The Fed will keep walking until something breaks,” said Eric Robertsen, global head of research and chief strategist at Standard Chartered Bank in Dubai. “I think it’s more likely that there will be a crack in the financial market before there is a crack in the economy.”
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After years of easy money policies, the Fed is leading central banks to tighten credit to fight painfully high inflation. Interest rates have risen sharply in the US, UK, Europe, Canada and dozens of smaller countries in the largest campaign of its kind to hit the global economy in one quarter of century.
Bond market volatility this month reached its highest level since early March 2020, when the Fed was forced to step in to buy $1 trillion of US Treasury securities. Slow trading in Treasuries – normally the most liquid market on the planet – has now led Treasury Secretary Janet L. Yellen to consider buying back some government securities from traders to help the market operate.
Markets grinding gears do not mean an impending financial crisis, analysts said. But the friction illustrates the bumpy transition the global economy has been making for more than a decade from ultra-low interest rates to an era of more expensive credit. With the Fed promising months of additional interest rate hikes, more market volatility is likely.
Globally, stocks have lost around $30 trillion in value so far this year, while bonds have suffered one of their worst years.
The financial reset comes as international risks mount, with war in Ukraine and deteriorating US-China relations unsettling markets.
Unpredictable links between finance and geopolitics have erupted in earlier eras, such as in 1998 when hedge fund Long-Term Capital Management collapsed during the Russian financial crisis, necessitating a US government-led bailout.
“There is a risk of a disorderly tightening of financial conditions that could be amplified by vulnerabilities built up over the years,” the International Monetary Fund warned this month in a report, which said financial stability risks had increased since April and are “significantly biased”. the wrong side.”
For more than a decade, when interest rates were low and the Fed actively bought government and mortgage securities, it was easy for investors to sell most assets.
Today, as the Fed and other central banks tighten monetary policy, normally liquid markets are becoming increasingly congested. Investors who want to offload, say, a Treasury bill, encounter significant delays or discrepancies between their asking price and what buyers will pay.
Since US government-backed securities are considered risk-free, their price is the key to determining the value of other financial assets. Thus, problems with buying and selling Treasury bills can infect other markets.
“Liquidity has masked weaknesses in other markets, and now we’ll see what they are. And we’ll see it in a bunch of assets,” said Megan Greene, global chief economist for the Kroll Institute.
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In the UK, as Truss was beaten for presenting a risky economic plan that had not been endorsed by independent analysts, UK pension funds became the center of the crisis.
Many fund managers had bet on a strategy called liability-driven investing, or LDI, designed to allow repos to generate higher returns during the period of low rates following the 2007-2008 financial crisis. With LDI, fund managers would essentially lend bonds in exchange for cash which they would reinvest to increase returns.
When yields soared on UK government bonds, funds were forced to quickly raise cash to make up the difference between the original value of the bonds they had pledged and their current lower price.
The fastest way to raise funds was to sell government bonds. But that set off a vicious circle: Falling bond prices led to demands for more collateral, which necessitated more bond sales, driving prices down further.
“It’s the kind of stuff we’ve seen in the financial crisis, and it’s something to be concerned about,” John Waldron, Goldman Sachs chairman and chief operating officer, told a press briefing. industry group this month. “We don’t know what the next risk is that will move the market.”
Indeed, new problems elsewhere could ricochet from market to market.
For example, companies with low credit ratings could be downgraded to junk status, forcing some portfolio managers to sell their bonds, Greene said.
As the value of these corporate bonds declines, other investors who bought them with borrowed money could face sudden demands for redemption. To raise funds to meet these “margin calls”, they would sell other assets, again triggering a decline in prices.
Companies that already have low credit risks find it harder to raise funds in the bond market. According to the Securities Industry and Financial Market Association (SIFMA).
But only 19% of corporate debt that needs to be refinanced by the end of next year is junk, according to Torsten Slok, chief economist at Apollo Global Management.
“The amount to be refinanced is quite manageable. The question is: how long do interest rates stay at high levels? Slock said.
If rates stay high, businesses and governments will feel a serious pinch.
During previous episodes of market turbulence, the Fed has often intervened to effectively stem the bleeding. In March 2020, as stock prices crashed and trading in Treasury securities stalled, the Fed cut its benchmark lending rate to near zero and added more than $4 trillion in securities to its balance sheet.
But with inflation now stubbornly high, the Fed is unlikely to be able or willing to cut rates or flood the markets with liquidity, analysts said.
“We are in an unprecedented hike cycle globally. … I’m more nervous about the system breaking because the Fed backstop just isn’t there,” said Priya Misra, head of global rates strategy for TD Securities.
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In the wake of the British debacle, the rise in interest rates is already clouding public finances. Highly indebted countries like Italy, despite rising energy costs, may have to reduce their borrowing plans due to higher costs. Already, 19 developing countries have to pay 10 percentage points above the roughly 4% the US government currently pays investors to borrow for 10 years, according to the United Nations Development Programme.
Government bond markets may have become more vulnerable to shocks over the past decade, according to a new report from the Financial Stability Board, a global advisory group.
Trading in the US Treasury market is less liquid than at any time since April 2020, according to a Bloomberg gauge.
The market freeze is the result of the sharp increase in the volume of government debt securities coupled with the impact of post-financial crisis regulations, intended to make banks safer, but which also made banks less willing to stockpile Treasury bonds on their own books while they look for a buyer.
Treasuries outstanding of $23.7 trillion are up more than $7 trillion since the end of 2019, according to SIFMA, reflecting the cost of fighting the pandemic and supporting the economy .
At the same time, regulations adopted after the financial crisis require banks to hold more capital in reserve to cover potential losses on the securities they hold.
The Fed also stopped reinvesting funds it receives from maturing securities, which some investors said hurt demand for Treasuries.
This month, the Treasury polled traders on whether they supported a potential program to buy back certain securities by the government and, if so, how it should be structured.
“We fear a loss of adequate liquidity in the market,” Yellen said this month.