After years of easy money, the global financial system is acutely sensitive to rate hikes

Autor: Article based upon analysis from Reuters Breakingviews | Link: Interest rate delusion may be biggest error of all
Timp de citit: 2 minute

The conditions for the bear market are met: falling prices of assets are there, even the pessimism is there. 

Major global bond and stock market indexes fell by more than 20% since the beginning of the year. 

30-year US mortgage rates have doubled since January, while British lenders are rapidly repricing their home loans.

Australia and China aren’t doing that well either, with real estate markets cracking.

Usually, bear markets set in before economic contraction takes hold. A look back at a typical US recession reveals a falling stock market several months ahead of GDP decline. 

Talking about U.S., where the Fed tightens monetary policy to restrain inflation, the dollar has soared against other currencies. 

In August, the euro traded at a two-decade low of 0.9903 against the U.S. dollar, with analysts predicting the single currency will continue to slide. 

Companies stopped merging, private equity buyout deals are creaking. High-yield bond spreads have widened, while many leveraged loans are trading well below par.

Was this expected? Not completely. Bull and bear markets often coincide with the economic cycle, which consists of four phases: expansion, peak, contraction, and trough. 

So it was always likely that asset prices would fall when the cost of borrowing eventually picked up. 

Now, the recent turmoil in the UK government bond market comes as a surprise, illuminating a dark corner of finance. 

CITESTE SI:  Silicon Valley Bank disappears but its legacy stays along

Kwasi Kwarteng’s “mini” Budget resulted in a huge surge in gilt yields, which sparked margin calls for defined-benefit pension funds using derivatives to hedge risk. 

Acquiring long-dated government bonds whose maturities match future expected payouts is a strategy known as liability driven investment (LDI). 

But at the end of last month one inflation-indexed government bond maturing in 2073 was down 85% from its peak just 10 months earlier. 

The pension funds faced margin calls on their loans, and the bond market seized up as they scrambled to raise cash.

Almost the same happened with the failed portfolio insurance strategies that triggered the October 1987 stock market crash. 

In both cases, market liquidity dried up just when it was urgently needed. Simon Wolfson, the head of UK retailer Next, cited by Reuters says he warned the Bank of England of this potential “time bomb” five years ago.

The broad derivatives complex proves to be the great unknown in this economic turmoil. After years of easy money, it proves that the global financial system is acutely sensitive to rate hikes. 

It also points to regulatory shortcomings, a lesson that should have been learned from past financial crisis. 

Rigorous stress tests that have consequences for failure are obligatory. Which for many pension funds are not tough enough.