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

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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.

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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

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