Nothing like a bear market to bring out the doom and gloom. There has been an ongoing debate throughout the year about whether the economy is on its way to a recession and, if so, whether it will be mild or severe. Now, however, there’s a more ominous conversation taking place: The risk of a financial crisis. The chorus of jittery voices has been swelling, particularly after chaos in the United Kingdom’s government bond market prompted emergency interventions from the Bank of England.
Concerns that the unprecedented acceleration in the pace of federal-funds rate hikes by the Federal Reserve could backfire on global financial markets are now front and centre. Among the fears are a “liquidity event” in credit where a major market actor gets caught unable to roll over its debt, or a calamity with a macro-economic dimension brought on by the explosion in the value of the dollar which crushes foreign currencies and induces defaults on dollar-denominated debt, as occurred in the 1990s to emerging markets.
That echoes the concerns earlier this week of former U.S. Treasury Secretary Lawrence J. Summers, who said in an interview Monday that he sees “tremors” in the markets. “We are experiencing a period of heightened risk, and earthquakes don’t arrive out of nowhere. First there are the little shakes,” he says. He said he wasn’t predicting a financial crisis, but “in the same way people became anxious in August of 2007, I think this is a moment when there should be elevated anxiety.”
At this point, the question for investors is whether the Fed will manage to follow through with its ambition of achieving price stability by increasing rates or will be compelled to abandon the inflation fight to ensure financial stability. “Financial crisis is a new consideration,” said John Canavan, a lead analyst at Oxford Economics. “If the financial stability risks are increasing, well, the fact that the Fed may need to respond to financial stability before it reaches its goals on inflation does make some sense.
None of this means investors should panic. The Fed has several bulletins in its chamber, and at its disposal, that it can roll out to calm markets in rapid fashion if it believes it must. Since the GFC it has imposed new facilities: the Standing Repo Facility (SRF) and the Foreign and International Monetary Authorities (FIMA) Repo Facility, that potentially would enable market makers to temporarily swap U.S. Treasury paper for U.S. dollars, although both are untested. The new facilities were intended to address a broad disparity between demand and supply that had arisen in September 2019, which had caused rates to spike by an outsize amount and contributed to worsening liquidity conditions in March 2020 because of the pandemic.
What are the warning signs?
Symptoms of increasing stresses in world financial markets have been bubbling quietly beneath the surface all year, they erupted into full view over the past fortnight, particularly as the BOE has been forced to intervene again and again in the market for U.K. government bonds, known as gilts, to keep it working.
No one is predicting that the United States will find itself in the same position, but market strategists say diminished liquidity in the U.S. government bond market should be a concern, particularly at a time when debt is at record levels and the Fed may be hamstrung in its ability to respond to the situation by the level of inflation. Illiquid conditions happen when buyers cannot be found for assets, demand disappears. That pushes prices lower and increases volatility and dislocations in markets.
“Treasury market volatility remains elevated with continued liquidity disruptions amidst an extremely uncertain macro backdrop and rate environment,” Canavan wrote in a recent note. “The drivers of these trends are unlikely to recede.
Indeed, the Financial Stress Index put out by the Treasury’s Office of Financial Research reached its highest levels since 2010 (excluding the spike in 2020 tied to lockdowns in response to the COVID-19 pandemic). The index gauges stress in the world's financial markets by analyzing 33 separate variables including yield spreads, equity valuations, default rates, funding, regions and other stress measures.
What brought on these new fears?
The UK gilt market locked up in late September with the 30 year gilt yield gaining 1.60% in four consecutive days, closing the day at 5.14% before falling 4% in one day to 4%. Bond yields move inversely with prices, and such large swings are not the norm in the government debt markets of developed countries.
The pound, suffering from a U.S. dollar on steroids, fell even harder after Britain’s new conservative government unveiled a budget that called for unfunded tax cuts that would have added to deficits and immersed the Britain central bank further into stimulative spending, even as it is trying to tamp down what is already a 9% inflation rate. The disruptions led the BOE to intervene on Sept. 28 to purchase bonds to help maintain market functionality and to support pension funds that were in danger of imploding.
Even as Tuesday, the BOE increased its gilts buys for the second time in two days before the planned conclusion of its buying program Friday. Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to U.K. financial stability, the BOE said in a statement. U.K. pension funds that had invested heavily in derivatives called liability-driven investments, or LDIs, tied to British government gilts during a very long low-rate nirvana had to be saved. By utilizing the LDIs, the pension fund freed up cash to invest in higher-risk, higher-return assets such as stocks, property and private equity.
It backfired when the BOE started raising interest rates in response to higher inflation and a falling pound. That led to losses on the LDI investments, which were compounded by margin calls, which happen when the value of accounts reach a certain low, and lenders demand to be repaid. This leads to forced sales of assets and sets off a destructive spiral. “Liquidity events come from surprises,” said Dan Kemp, the global chief investment officer at Investment Management. “The U.K. mini-budget was a huge surprise. In fact, when everyone crowds the doors at once, it creates a problem with flow.”
What is the impact of the Fed’s battle against inflation?
The Fed has been lifting rates aggressively this year at a pace not seen since the 1980s and is widely expected to do so at least through year’s end, bound and determined to dampen inflation that is proving to be a dogged foe. It is also using another policy tool, known as quantitative tightening QT for short to put upward pressure on rates: That’s outright shrinking its balance sheet by allowing the Treasuries and mortgage-backed securities it bought during the pandemic to aid the economy’s recovery to roll off its balance sheet. That pushes down the prices of those assets and raises interest rates.
The rate increases have helped push the dollar to its highest level in two decades, pressuring currencies around the globe and stoking inflation. That has raised the specter of defaults in developing countries that have dollar-denominated debt. Certainly, in May, Sri Lanka defaulted for the first time in its independent history on foreign debt, amid spiraling inflation and a free fall of its currency.
“There may be a three-stage bear market: the reset of valuations at the time of higher rates; the reset of earnings during a recession; and a liquidity shock,” says Sebastien Page, head of global multi-asset and C.I.O. of T. Rowe Price. ``So, these stages appear to be going in order. But the recession may be short or shallow, and most of its likelihood has already been priced into markets. And leverage in the system among families, companies and banks is far lower than in 2007, and low overall by historical standards. There is a need to keep an eye on liquidity risk, which has a nasty habit of emerging quickly. The repo markets are where firms trade repurchase agreements on short-term usually overnight collateralized loans, in which one firm sells a Treasury security to another firm and agrees to buy it back at a higher rate by a particular date.
What will the Fed do?
The Fed chair, Jerome Powell, has repeatedly said the central bank will keep its pedal to the metal until there are clear signs that inflation is under control. Fed governors have struck a similar hawkish tone in recent weeks. Futures activity via the CME FedWatch Tool pricing in an 80% probability that the federal-funds rate will increase by a further 0.75 percentage point when the Federal Open Market Committee next meets in November.
Markets have struggled to come to terms with a “new normal” where rates have moved from close to zero or even sub-zero for much of the last 15 years back to rates that are more in line with where they should be, Canavan says. That’s added to volatility. Canavan is predicting a 0.75 percentage point rate increase when the Fed next meets in November and a 0.50 percentage point hike in December. He doesn’t foresee additional rate hikes in the year ahead, but expects the Fed to stay the course on quantitative tightening. And he foresees a mild recession in the first half of 2023 and a turnaround in the second.
When are investors going to get that all-clear signal?
“What we’re experiencing is an economic pulse that is caused by the pandemic,” says Kemp. “Some things that seem like they will be permanent will fade. Investors must manage an array of potential outcomes and allocate for what lies ahead. We would urge investors to become even more granular in their thinking about the markets.”
Investors should construct portfolios in an “up from the bottom” approach and not try to make them conform to macroeconomic winds, he says. Concentrate on the individual companies, sectors, industries or regions to which those valuations are applied that actually represent bargains, and not just premiums versus their historical averages. Invest from a long term perspective and stay invested,” Kemp says. Markets are likely to continue on under pressure until liquidity in the Treasury markets returns, volatility subsides and the dollar backs off.
