Dallas is almost 5,000 miles from London. But when the UK gilt markets imploded last week — forcing the Bank of England to make a £65bn intervention to support pension funds — the drama left Richard Fisher, former chair of the Dallas Federal Reserve, wincing.
Fisher has warned for years that a decade of ultra loose monetary policy would create pockets of future financial instability. So he sees the British gilts drama (which occurred because the pension funds mishandled highly leveraged bets) not as an isolated event — but as the sign of a trend.
“This [foolish strategy] always happens when rates are near the zero bound and things have gone to an extreme,” he told CNBC, noting that the crisis is “an indication of other things that are likely to pop up” because investors and institutions have been dangerously overleveraged and “thinking that rates will stay low forever”.
Quite so. Markets are already becoming jittery and volatile, and not only in the UK. An index of market stress compiled by Washington’s Office for Financial Reporting, for example, has now jumped to a two-year high.
And while Fisher did not identify where “other things are likely to pop up”, I suggest there are at least four places that investors (and regulators) should now watch closely (aside from other pension funds).
One is the state of open-ended investment funds, or vehicles that let investors redeem assets at will. As the IMF notes in its forthcoming financial stability review, this sector has swelled to contain $41tn of assets.
Many funds are run conservatively. But some have moved into illiquid assets to juice returns — and the IMF is now warning that this liquidity mismatch “contributes to volatility in asset markets and potentially threatens financial stability”, if investors start to panic.
Some observers might respond “well, duh”. After all, liquidity and duration mismatches are usually the source of financial dramas, and this one is not new. But it needs to be watched, particularly since nobody seems to know just how big the potentially illiquid exposures are.
A second issue is government bonds. Last week’s gilts crisis partly arose due to the idiosyncratic nature of the British pension fund system. But not entirely: all western government bond markets are grappling with the fact that liquidity increasingly tends to evaporate at moments of stress. One reason is that big banks no longer act as market makers, due to tighter regulatory controls.
This liquidity issue created a near-disaster in Treasuries in March 2020 and some observers fear that a so-called “volatility vortex” in US markets could emerge again. And, while central banks are trying to fix this, it is not easy to do.
After all, as Paul Tucker, former deputy governor of the BoE, noted this summer, arguably the only truly effective “fix” would be for the central banks to promise to always offer liquidity for supposedly “safe” assets, such as government bonds, in a crisis. The BoE did this as an emergency measure last week. But no central bank wants to make a permanent pledge, since they are supposed to be reducing, not raising, market meddling.
A third issue is housing. As the Bank for International Settlements recently noted in a trenchant report, the global property market has recently looked odd by historical standards. Correlations between different geographies have surged and house prices rebounded surprisingly swiftly after the pandemic recession.
More notable still, prices kept rising earlier this year, even after monetary tightening started. This may reflect structural shifts, like working from home, but it was also a consequence of the past ultra loose monetary policy.
However, in recent weeks there has been a stunning surge in the 30-year fixed US mortgage rate in America to 6.75 per cent, its highest rate since 2006. That will almost certainly cause house prices to fall in the coming weeks. Brace yourself for volatility — and stress — in mortgage bonds.
A fourth issue is private capital. Arguably the biggest difference between the current tightening cycle and previous ones (aside from the eye-popping scale of previous monetary loosening) is that much of the free money frenzy occurred in the private equity and venture capital funds, not (just) public markets.
This makes it harder than before to track pain, as the monetary cycle turns. We can see that junk bond prices have recently tumbled; we cannot track the true value of assets held by private funds. Maybe they are marking these down correctly. But I doubt it, particularly given that they are increasingly selling assets to each other. Expect a future reckoning.
This list of potential flash points is not comprehensive (emerging market assets are another story.) Moreover, they may not “pop up” immediately, given how much money is still swirling around as a result of past loosening. One telling detail about the OFR’s market stress index is that it increased primarily because of higher market volatility — not deteriorating funding conditions. The latter still look quite stable, in the index.
But “still” is the keyword here: if central banks keep hiking rates, funding will inevitably shift too. Investors should brace themselves for more surprises, in places other than the UK. Unless, of course, next week’s IMF meeting in Washington reveals that central banks are about to perform (yet another) U-turn.