Yesterday, September 28, for a day, global stocks and bonds rallied after the Bank of England stepped in and said it was setting aside £65bn ($72 billion) to buy bonds over the next 13 working days. (It’s a limited-time offer that expires on October 14.)
Today, the global selling has resumed. As of the close in New York time, the Standard & Poor’s 500 was down 2.11% on the day.
The rally yesterday was, in my opinion, a knee-jerk reaction by investors and traders who saw the Bank of England’s move as evidence that the central bank Put lived. And that central banks would, of course, rescue the financial markets. According to this interpretation, the market was upset, and, as usual, central bankers soothed it with a bundle of cash. Which led markets to hope that other central banks, especially the Federal Reserve, would pivot away from a policy of higher interest rates in the face of the damage done to financial markets.
Today’s resumption of selling is, I think, a recognition that yesterday’s rally was based on false assumptions.
Today on further thought, investors and traders have concluded that global markets are even scarier than they looked to be a few days ago. And they looked scary enough then.
First conclusion today: The convulsion in the United Kingdom isn’t going to lead to a global pivot away from higher interest rates because the cause of the Bank of England’s intervention is specific to the United Kingdom. The Bank of England intervened because pressures that had sent the pound down to near record lows against the dollar and that had led to a collapse in the price of government bonds, the famous Gilts of English literature, threatened to produce massive margin calls that would send major U.K. pension funds into crisis. (After the new Conservative government announced a new “mini-budget” with big tax cuts and big increases in spending, the yield on 30-year government bonds climbed to 5%, just about 125 basis points higher than before the release of the plan. Bond prices moved strongly in the opposite direction.)
Second conclusion: The pension fund crisis that led the Bank of England to intervene has a scary resemblance to the U.S. subprime mortgage crisis that evolved into the Global Financial Crisis. The reason that the collapse in the market for sub-prime mortgages and the financial assets based on them led to a global financial crisis was that modern markets have evolved so many complex ways to shift around risk using derivatives that no one can be quite certain what investment institution is holding how much risk. Which leads to big uncertainties about who is or isn’t going to be able to backstop that risk.
U.K. pension funds, like pension funds globally, use derivatives to help match their liabilities–future payouts–to current assets and income. Those funds loaded up on long-dated debt to match their liabilities to pension holders and then used derivatives to lay off part of the risk that higher interest rates and/or higher inflation might hit the price of those bonds. The big drop in the pound and the Bank of England’s own 50 basis point increase in interest rates last week had already significantly hit the price of long-dated government bonds. The tax cut/spending increase mini budget just pushed the drop in prices to the point where many pension funds feared they were looking at margin calls. (Projections now see U.K. interest rates rising to 6% in early 2023 from 2.25% now. So you can see why pension funds might have wanted to hedge their risk.)
And if you can’t meet a margin call, you face a forced sale of your collateral.
That scenario would have resulted in a huge plunge in the bond market. Which is why the Bank of England stepped in.
The fear in the markets watching these events unfold isn’t of an exact replay of the U.K. pension funds/derivatives scenario, but that some market move as a result of the Federal Reserve winding down its balance sheet, say, or the European Central Bank raising interest rates to fight inflation and defend the euro (even as the European economy sinks into recession) or a move by the People’s Bank to defend the yuan in a stumbling economy awash in bad debt would ripple out in unexpected directions, and, leveraged by the interconnectedness of risk markets using derivatives, create another bigger crisis. One that might grow to be the equivalent of the Global Financial Crisis.
But this time with central banks already sitting on massively bloated balance sheets.
Wonder why, today, worry has moved back to the top of the market sentiment agenda?
