Fractured markets: the big threats to the financial system | FT Film

Fractured markets: the big threats to the financial system | FT Film

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[Music] this is the story of a world that became addicted to low interest rates it's a tale of what can happen when the era of cheap money comes to an end investors have just been spoiled for like two decades by super low interest rates and it's over the game is up inflation is here for the first time and most investors living memories and this changes everything 30 years of falling bond yields perhaps coming to an end suddenly we're at an inflection point we're seeing some cracks in the financial system what a decade of easy monetary policy did was encourage people to take greater risks T rates rise as quickly as they have often there are things that break at no time have we seen such a complicated constellation of risks the only when the Todd goes out that you see who's been swimming naked so let's rewind to 2008. [Music] Global financial crisis that was due to leverage too much borrowing particularly in the U.S mortgage Market result of that was the need for incredible liquidity injections into the financial system in the immediate aftermath of the global financial crisis central banks really had to sit on their hands economies globally were so lackluster and the recovery was so slow and central banks weren't grappling with high inflation they were grappling with what to do with incredibly low inflation in central banks around the world respond to the recession that follows by slashing interest rates by buying up vast quantities of government debt under their quantitative easing programs this was a new thing really we saw central banks buying back huge amounts of Government Bond markets trillions and trillions of dollars worth of government ious ended up being owned by central banks instead of by traditional investors and they did set for the Paradigm if you will of inexpensive money and a feeling that there was a fed put below the markets Federal Reserve and central banks globally were able to achieve this because there was no inflation financial markets in particular get conditioned to this world where every time something goes wrong a central bank comes riding to the rescue ever since that point we've had loose monetary policy with interest rates heading all the way down to zero if you went back to a couple of years ago most of the Government Bond markets of the world had negative yielding government bonds which is just extraordinary now that existed up until the pandemic hit and then you had central banks and governments step in pretty aggressively to support the economy while we put the economy into a deep freeze the global financial crisis followed by a Eurozone crisis followed by covid three big things coming in Rapid succession in a way we've almost forgotten what normal looks like there is everything that leads up to covid and the invasion of Ukraine and there is everything after what's changed in one word inflation there was a belief that inflation was transitory that this was caused by supply chain issues during covid by a tight labor market because of covid and that would recede and you'd see inflation coming down a realization by central banks that this was not the case inflation was stickier earlier this year led to this very steep rise in interest rates the Federal Reserve officially changed its monetary policy framework to tolerate higher periods of inflation what the FED did not Envision that this framework would become operational just as inflation was starting to become a much more persistent issue post covered everybody wanted to get out there again and start flying start eating out in restaurants at the same time that we had people who had left the labor force and a lot of Supply bottlenecks the perfect breeding ground for some inflation sustained by the war in Ukraine so suddenly you had Energy prices going through the roof the world has changed the world is different inflation is here for the first time and most investors living memories We've Ended up in a world where inflation's at 10 percent now what we have is central banks around the world scrabbling to stop inflation running away in every major economy except for in China and in Japan we had central banks that are aggressively tightening rates and also with drying liquidity from the markets the FED is shrinking its balance sheet the bank of England has started quantitative tightening the ECB is starting to talk about quantitative tightening financial markets definitely got used to this notion that interest rates would be low for for quite a long time people really did not grapple with the fact that interest rates were going to have to be significantly higher what we hear from officials is that it's not going back to the way it was anytime soon you have inflation for the first time in 40 years limiting their ability to use a monetary policy and inject liquidity in the same way so as a result we're seeing a drainage of liquidity globally really higher rates and a new paradigm you can no longer buy up government debt every time there's a wobble in the markets because you need to concentrate on your main mission which is fighting inflation there's so much uncertainty that investors are pulling their money out of the markets into cash as well so that's further with frying liquidity the first really big rake that has been stepped on here is in the UK pension sector the bank of England are taking further steps to control inflation access let's rewind to September the 23rd we have the guilt Market which is expecting this new government to come out with a package of energy subsidies what they didn't expect is that the government would pile a load of unfunded tax cuts on top of this borrowing even more money than the market realize it was going to be the supply of guilts the supply of new debt that the UK government has to raise has suddenly gone up the UK Government Bond Market generally on the boring side it's kind of a rinky dink little market compared to the U.S treasury's market it got fried the market freaked out because essentially the government was saying we need to borrow much more money at a time where it's going to get even more expensive to borrow money this drove a sharp sell-off in the UK Government Bond Market the speed and scale of the move in the guilts market was unprecedented and this is what caused a shock the supply of something goes up investors respond by selling it you see UK borrowing costs leap higher on the day of the budget it was going to result in the biggest amount of guilt issuance that we've ever seen the more bonds that are issued the the more that the market has to buy at the lower price the government will have to sell those at pound crashes to its all-time low against the dollar usually higher interest rates would be good for your currency but we have this this sense that the International Investment Community has lost confidence in UK economic policy making and that caused a whole bunch of foreselling in the ldi market liability driven investing or ldi has been at the center of this this is a strategy used by certain pension schemes to protect them against big swings and interest rates the reason that they need to do that is because moves in long-term interest rates mean that their liabilities the money that they have to pay out to pensioners for decades in the future swings up and down wildly now one way that they can protect themselves against that is by owning lots of guilts guilt long-term government bonds that will also see Wild swings in their prices as long-term interest rates move that works if you were able to fill your pension portfolio with 100 guilt in practice it doesn't work that way there are shortfalls in the funding of these schemes so they need to buy riskier assets as well the returns that you can get out of bonds have been falling for years so they think well we need to enhance returns they need to hedge themselves against the risk that Bond deals could fall further and that's where derivatives come in that effectively synthetically create the same effect of holding long-term guilt but using leverage using borrowed money the problem is that if bond yields rise Pension funds have to pay out that money that can mean that they have to sell assets really quickly as guilt yields climb rapidly in the wake of the budget that meant that those swap positions moved against the pension fund the type of moves that are supposed to be only seen once in a generation in the guilt Market we had that happening three days in a row so when the guilt price fell the yields Rose and this meant that Pension funds faced collateral calls they had to raise new cash and they had to raise it fast selling of UK government bonds meant more selling of government bonds and it it spiraled incredibly quickly and it very quickly became a threat to financial stability in the UK this is a slow-moving industry these guys are not used to responding to market conditions on a day-by-day basis ldi was a strategy that was sold to companies as something that you can lock away in the draw and not think about it wasn't supposed to be something where pensions trustees and where companies had to think fast about which assets they can liquidate in order to meet margin calls on their collateral positions if the bank of England hadn't stepped in there would have been this Doom Loop of asset sales where it becomes a sort of self-fulfilling prophecy and you sell prices into a falling market and prices keep on falling and then you risk contagion across other parts of the market the bank of England announces that it's prepared to buy up to 65 billion pounds worth of guilts of long-term guilts over the next 13 days which effectively looks like a return to the days of quantitative easing precisely at the time when they're trying to back away from policies like that the bank of England had to step in something had to give ordinary people who pay mortgages could see that the rates on those mortgages were shooting through the roof mortgage lenders were pulling out of the market it could have developed into a financial crisis the ldi dynamic you know exposed the stresses that can happen in the system when you have a very sharp rise in interest rates lose fiscal policy combined with inflationary backdrop are very dangerous and I think the financial markets really forced a coherence in fiscal policy the bank of England's response to that was a tactical response inject liquidity for a moment in time to reverse the quantitative tightening policy they had if the bank the Bay of England hadn't stepped in as the market maker of Last Resort I think we would have had a Lehman type event where you had a bunch of UK pensions go bust Pension funds knew that the bank of England wasn't going to let them go bankrupt there was some reticence to unwind their positions which is why the governor Andrew Bailey created this deadline and really stuck to it so that Pension funds would have to unwind it rather than just handing it over to the the bank of England and allowing the bank of England to take the losses it was very very tightly targeted it wasn't a monetary policy move they were at pains to to point out that you know this isn't more easing this is just us making sure that the the system can hold central banks like the bank of England wear two different hats one of them is to set monetary policy and control inflation and the other one is to protect Financial stability now for most of the last decade those two things have worked pretty well hand in hand when you had no inflation and low interest rates it was easy to ride to the rescue on financial stability grounds without compromising your monetary policy with high inflation you can't do that anymore your financial stability function no longer pushes in the same direction as monetary policy the question is very much whether this is a very British problem or whether the UK is a taste of of things to come the crisis that we've seen in the UK pension fund Market could be a Harbinger what's to come elsewhere when you see rates rise as quickly as they have often there are things that break they're going to be a bunch of market dislocations and it's going to be central banks that are going to have to step in to paper them over even as they're trying really hard to fight inflation one of the most famous and off repeated phrases that you ever hear in financial markets is the famous quote from Warren Buffett it's only when the tide goes out that you see who's been swimming naked it's a great metaphor for where we are now because as a liquidity is withdrawn we can see where all the vulnerabilities are because they're going to blow up which investment strategies Which business models no longer work in a world of rising interest rates once all of that lovely liquidity is gone then you find out what's really at risk in a bull market almost everything goes up and you can't see the problems in the portfolio it's only when the tide goes out or the markets turn that you see where the issues are or who's got their trunks down if you're looking for who's been swimming naked there's a lot of skinny dippers out there the places to look are wherever there's leverage in the system wherever there's borrowed money when markets move a long way quickly people lose money on their leverage positions and they're forced to sell Assets in a disorderly way which exacerbates the moves and creates even wider problems after the financial crisis Global Regulators did a lot of work to make the bank safer as a lot of the risks got pushed away from the banking sector into what we call the shadow banking sector non-bank players such as hedge funds private Equity Pension funds and asset managers the unregulated parts of the financial sector before the financial crisis Regulators knew that most of the leverage was in the banks the problem is now we don't really know exactly where the Leverage is if this can happen to the guilt Market it could happen to the Japanese government bond market it could happen to the U.S treasury's market we have to be ready for the possibility that bonds just don't work like they used to anymore the market dislocations and price moves that we see in global markets over the next year will be as Swift and severe as what we saw in the UK with the ldi blow up markets broadly globally are very stressed already partly it's driven by a disagreement between governments that want to boost the economy and central banks like the bank of England who want to slow the economy and that store is going to replay in other parts of the world including probably this winter in Europe the European Central Bank has to set policy for lots of countries that means one of the things that they're really worried about is the gaps opening up in bond markets between what it costs different countries to borrow and this is particularly for countries with weaker economies like Italy or Greece so far they've been able to get away with the threat of buying more Italian bonds to stop this happening but again they face a similar Dilemma to the bank of England how do you convince people that you're still committed to fighting inflation and at the same time commit to buy billions of Euros of Assets in order to stop these cracks opening up in the financial system the bank of England certainly sets a precedent for the FED here you can imagine a situation where the FED is forced to intervene to protect Market functioning while at the same time they're moving in the opposite direction in order to reach their monetary policy objectives it's a very difficult tight rope to walk when your financial stability and your monetary policy functions are pulling in different directions one of the big worries in the US is the smooth functioning of the market for U.S treasuries which is the world's largest bond market it's a fundamental part of the world's Financial Plumbing everything depends on the fate of the U.S treasuries market but there are some

real cracks there lots of participants in that market have been complaining that liquidity is getting worse but it's harder to trade bonds without moving the price but sometimes it's simply impossible that's a worrying sign when you're talking about a market that's so fundamental to the Global Financial system the US bond market is the interest rate that sets the global interest rate everything that happens to U.S treasuries has implications for Equity markets property markets your mortgage rate everything is based based on U.S treasury bond markets as the Federal Reserve moves to Titan monetary policy by raising interest rates and also by winding down its portfolio of treasuries people are worried that those problems may get worse and that you may end up in a place where the treasury market simply isn't functioning the Jersey Market is hands down the world's most important bond market so dysfunction in that market is just not going to be tolerated from the Federal Reserve that being said there have been cracks in March 2020 there was this big broad dash for cash as investors panicked in the face of the pandemic the nightmare scenario honestly is that we get anything like the sort of volatility that we've seen in guilts happen in U.S treasuries something similar in the treasury market is probably a disaster for the global economy Bank of America has done a lot of research into these fragilities that that it can see occurring in the U.S treasury's market if the treasury's market fails to trade for a period of time various credit channels including corporate household and government borrowing and securities and Loans would cease this could lead to events such as U.S government debt default not good

inability to convert treasuries to cash or meet corporate household or government obligations globally the inability to produce benchmarks that form the backbone of the derivatives Market the inability to issue trade or hedge debt of corporates municipalities and insurance companies Banks I could go on potentially one of the biggest risks to financial stability that there has been anywhere since the housing bubble of 2006 to 2007. we're facing into a recession across developed markets a Slowdown in China unbelievable geopolitical risk a war in Europe I think the flight to safety might be a trend that we'll see over the next year that should support the U.S treasury market The Logical conclusion is that there's simply no way that U.S authorities would stand back and and let that happen but yields can rise because prices are falling in bond markets much more quickly than we have become used to so if you have modeling for any kind of hedging contract anything that's predicated on rates moving slowly I would suggest you check the fine print on that pretty quickly we've gone from a world where central banks were the number one buyer of Government Bond issuance to them being the biggest seller of government bonds for me and other Bond investors we don't quite know how well the global markets will be able to digest this additional Supply at the same time that government borrowing is already quite High no fed official has officially said uh you know we need a recession in order to tame inflation but all signs kind of point to to that having to be the case the economy and the country have been through a lot over the past two and a half years and have proved resilient chair J Powell acknowledged the fact that a recession is a real possibility and he said something that I think really shocked investors everyone wants there to be a painless way to bring inflation down and there just isn't and we constantly hear them reference this 1970s period when inflation got out of control because policy makers prematurely eased policy and that's just not a mistake that they're willing to make this time around Jerome Powell has been very clear that he's willing to accept a weaker stock market in pursuit of lower inflation but if the credit Market seized up and seized a function I think the the Federal Reserve just like the bank of England would be very quick to intervene and manage that issue big concern is is how severe of a crisis we could have going forward and we often find out when it's too late the Japanese government bond market is an outlier inflation is incredibly low in Japan interest rates are held at more or less zero and bond yields are held incredibly low the bank of Japan will probably have to unravel this policy if inflation does start to get sticky the big question that investors are asking is can Japan do this can it pull this off without lighting a fuse under the massive Japanese Government Bond Market lots of people have spent years looking for some sort of disaster in the Japanese government bond market and they've been disappointed but what is to say that that market can't do this and what is to say what the reaction of Japanese asset managers would be to that nobody knows the answers to these questions one flash point is what's going on with emerging and developing economies these are highly indebted countries intimately affected by Rising borrowing costs globally by a strong dollar they also do not have the kind of fiscal robustness that would allow them to to perhaps weather through various crises there's this amazing stat from the IMF 60 of low-income countries are either near or at debt distress already we could perhaps see a wave of defaults going forward ultra low rates certainly fueled speculative excess so we saw that in unprofitable growth companies we saw that in private Venture Capital back companies we've seen it in the crypto world where there's a lot of opacity one area that we might see potential mines next year is U.S market for unlisted tech companies we've seen a big sell-off enlisted tech companies this year we're expecting trouble to fall over into the private markets at some point next year companies raise money at Sky High evaluations during the good times and as interest rates rise they may be forced to do what's called which is when they raise money at a big discounted valuation UK specifically I think the mortgage Market is a bit of a risk as well aggressively in most mortgages are pretty short term in the UK relative to the US you could end up having these fixed term mortgages turn variable with much higher rates that could blow back on the bank your mortgage rates are set related to The Guild Market yields so we saw UK mortgage rates start to hit six six and a half I even saw seven percent mortgage rates when central banks are pouring money into the financial markets and they're Rising it's an incredibly easy environment in which to invest a rising tide carries all those low interest rates and Ultra accommodative monetary policy has definitely allowed for more risk-taking than I think would have been possible when you can't earn a decent yield a decent interest rate from buying the safest assets it pushes you into more dangerous areas encourages you to take on Leverage to use borrowed money to juice up your returns we've had a generation of investors more than a decade that have gotten used to these Tailwinds from from low range low interest rates and and the ability to to fuel the speculative success investors should absolutely be braced for more surprises there are pockets of hidden leverage in this economy and financial system that policy makers have not yet identified the big concern is how quickly those get exposed nobody thought that inflation could jump to 10 percent what if we've got double-digit inflation in in major economies and actually we're going to 15 the situation is going to get much dicier we heard this from the IMF the worst is yet to come for the global economy and the Global Financial system that's pretty strong language are there any reasons to be cheerful uh we saw with the UK pensions crisis that the central banks still are able to step in and stop the worst problems without compromising their their commitment to fighting inflation Bank of England are taking further steps maybe the mess that happened in the UK around the time of the mini budget is enough of a wake-up call to the rest of the system if it's not then we're going to get accidents like this happening over and over again for the next few years for inflation rates to stay this high you're going to need the oil price to keep going up and up and up if we ended up with some sort of Peace in Ukraine and stability then we forget about all the the extra billions and trillions that governments and consumers going to have to be spending on energy bills there has been a bit of a callback in U.S inflation in the data for October and the FED is indicating that maybe it won't have to raise interest rates quite as quickly as it had previously told the market it would so that takes the pressure off a bit but it's still well above Target and the pressure is still very much on China has been a nicero covid policy for a very long time if China opens up in 2023 then that could produce a significant boost to economic activity around the world a lot of the pain has been felt in 2022 we've seen rates rise very sharply we've seen evaluations contract very sharply markets are all down and there's been a process of understanding that we're in a different type of Paradigm higher rates higher inflation for longer it's hard to imagine that we can tighten monetary policies so aggressively have a downturn in the economy and not see a bunch of defaults this crisis has perhaps less potential to spiral through the financial system we've got the plumbing set up much better than we did in 2008 for central banks to go ahead and step in but at the same time until inflation can be brought back down and in until central banks are in a position where they can reassure the markets rather than scaring them this is going to continue this is the point where policy makers Reg ulate this seriously we cannot take the risk that people's savings are at risk on Julie that people's pensions are at risk that house prices could come under pressure or more importantly the people's mortgage rates could absolutely shoot through the roof we could see trade unions On The Rise Again having been extinct effectively since the 1980s and 1970s and we could see wages start to increase the system was absolutely addicted to cheap money one investor was putting it to me the other day it's absolutely naive to think that we can get out of this low interest rate environment without some sort of blow up [Music] [Music]

2022-12-27 10:53

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