Federal Reserve Chairman Jerome Powell pauses during a news conference September 21, 2022 in Washington, DC.
Saul Loeb | AFP | Getty Images
Writing about central bankers’ actions last week, I implied that the rapid hike in interest rates, led by the US Federal Reserve, would soon lead to a major collapse in financial markets, be it domestic or international.
Well, it seems that day has come.
On Wednesday, the Bank of England, the historical model on whose practices modern central banking is based, reportedly intervened in the UK bond market to prevent rising “gilt” yields from sending certain UK pension funds into the abyss. (Gilts are British bonds named for the gold-rimmed paper on which they were once printed.)
What many of us don’t know is that some UK pension funds, which together have assets of around $1.7 trillion, have used derivatives both to hedge against a rise in interest rates and to amplify gains on certain types of trades.
In other words, pension funds used borrowed money to speculate in the financial markets.
As interest rates soared, some of these trades collapsed in value, leading to margin calls for the same funds and triggering a near-Lehman moment in UK financial markets.
The BoE stepped in and bought bonds, dragging down long-term yields there by over a full percentage point and also dragging down US 10-year Treasury yields here. That led to a knee-jerk rally in bond stocks in Europe and the US on Wednesday that was all but wiped out just 24 hours later.
“An even bigger break” ahead
We are on the cusp of an even greater disruption in the global financial architecture as Federal Reserve officials now reinforce the need for a rate hike to combat what appears to be falling inflation, regardless of the consequences.
Some Fed officials acknowledged that even in the midst of a recession, rates will continue to rise and that rate hikes will not stop until inflation falls to the Fed’s stated 2% target. Whether this means raising rates above the currently perceived target of 4.6% or keeping rates high for an extended period remains unclear.
What is clear is something I have been implying for quite some time – that the recession is a feature, not a flaw, of Fed policy, reflecting the policy decisions of the late Paul Volcker, who pushed interest rates to 20% in the early 1980s to avoid them to induce an inflation-killing recession and tame inflation that has raged for over a decade.
I have argued that the historical analogue chosen is the wrong one to use as a guide to current politics.
For the historical record, while successful in taming inflation, Volcker’s draconian policies also had attendant and unexpected costs that extended even beyond the deep double-dip recession that followed.
Rapidly rising US interest rates weighed on Latin American nations, which had borrowed significant amounts of money from US commercial banks in the 1970s.
This debt, largely denominated in dollars, has been weighed down by a combination of higher interest rates and falling local currency values, effectively and significantly increasing the debt service burden for these countries.
As interest rates rose sharply, Latin American nations threatened to pay off their outstanding debts, an event that could have effectively left many US money-centre banks insolvent. Volcker had no choice but to stop raising interest rates and cut them to relieve the US banking system.
Even in these circumstances, the Fed hiked rates until something broke.
They would do so again in 1987 (October stock market crash), 1994 (Mexico peso crisis and Orange State bankruptcy) and try in 1997 and 1998, but they were halted by the Asian currency crisis and Russian debt default and then massive failures in long-term capital management. LTCM was a hedge fund that used so much borrowed money from US banks to speculate on international bonds that its collapse again threatened the solvency of the entire US financial system.
The Fed must stop soon
It seems that we are reaching this threshold again or have already passed it.
The near collapse of the UK bond market may just be the canary in the coal mine, suggesting there are unknown or unrecognized niches of leveraged speculative betting in both near and far corners of the world.
If I’m right, the Bank of England’s forced purchase of UK bonds signals the first central bank to squint at tighter monetary policy, but it won’t be the last. It’s only a matter of time before the next shoe falls.
If history is any guide, and in financial markets this is almost always the case, the Fed will be forced to pause, if not reverse, policy in the relatively near future.
You can deny it. You may not want it. They may refuse to even acknowledge the possibility of such a drastic change in policy.
But they will change.
I recall a remark made to me privately during the collapse of Long-Term Capital by former Fed Chairman Alan Greenspan, when he was being pressured to see the firm fail.
He said that in theory he would agree that letting the markets deal with failure is a good idea, but “in practice it’s not a social experiment that I’m willing to do.”
His words will ring true again in the coming days and weeks.
—Ron Insana is a CNBC contributor and Senior Advisor at Schroders.
Comments are closed.