Market turmoil and the problem with the central bank panic button.
What if the solution to past problems relating to market liquidity crises makes the next crisis worse rather than better?
Like a Shakespearean tragedy, HBO’s 2019 mini-series ‘Chernobyl’ came in five acts. Unlike tragedy, the final episode of Chernobyl wasn’t a denouement where the protagonist died, but rather a court-room drama (in fact a Soviet show trial) which acted as an exposition of the series of mistakes, oversights, displays of arrogance and general incompetence that lead to the nuclear disaster in 1986.
For the prosecution, the scientist Valery Legasov (played by Jared Harris) describes the events that lead up to the moment the reactor exploded, but then, in the big reveal, suggests that all of the sloppiness and hubris could occur safe in the knowledge that there was an emergency shut-down procedure, activated by hitting the ‘AZ-5’ button, that would kill the nuclear reaction dead in an instant by dropping the boron control-rods back into the reactor.
But there was a flaw - the tips of the control-rods were made of graphite, not boron, and graphite speeds up reactivity rather than inhibiting it. What this meant was that at Chernobyl in 1986, the fail-safe procedure of AZ-5 actually meant accelerating reactivity in a power surge rather than stopping it. The kill button was in fact a detonator, and the rest is history.
According to Einstein, the definition of insanity is doing the same thing over and over again expecting different results. With respect to financial markets and in particular liquidity events and the extreme volatility that ensues, there is generally an expectation that if things get too hairy, especially in the bond market, central banks will intervene by purchasing assets or cutting rates, thereby stabilising the situation. In the US, this has been the Fed’s playbook since the Long Term Capital Management crisis in 1998, and so far it seems to have been a safe bet. So far, AZ-5 has worked.
Yet unlike the experiment Einstein had in mind, financial markets and economies change and develop, and therefore unlike the necessary ‘all else equal’ of a scientific investigation, any given financial situation is always different, and therefore so are the consequences of an intervention. While the bailouts and quantitative easing (QE) following the global financial crisis ‘solved’ the immediate problem back in 2008-9, they also lead to the formation of large asset bubbles, while central banks’ low-rate policies in the 2010s permitted a huge build up of debt and malinvestment.
In the last twelve months, and despite central banks in general tightening policy through rate hikes while also reducing their balance sheets through quantitative tightening (QT), we’ve had two financial crises. This time last year, the UK gilt bond market blew up, while in March, the US banking system began to creak when Silicon Valley Bank and others became insolvent. Bond buying by the Bank of England and a new emergency lending facility from the Fed (the Bank Term Lending Programme or BTLP) seemed to resolve the respective problems in the short-term.
Yet gilt yields are currently hitting new highs and US bank equities are on the slide once again, suggesting that those interventions were more band-aid than solution. If US 10yr Treasury yield head north of 5%, the knock on effect on asset prices, collateral values and implied US Treasury funding costs may hit the sort of level that turns market turmoil into the sort of panic that demands a Fed intervention.
As ever, an event is needed, and the volatility in the US Treasury market, with the MOVE bond volatility index (see graph below) hitting 140 again this week (implying nearly 10 basis point moves per day in the 10yr Treasury yield), is the sort of indicator that something is starting to go wrong.
It’s not just the market itself which is looking twitchy. Respected figures in the financial community are starting to ring the warning bell. Ray Dalio, former CIO of the world’s largest hedge fund Bridgewater, said last week that he saw a debt crisis forming, in part driven by supply and demand imbalances1. Jamie Dimon, CEO of JP Morgan, America’s largest bank, also warned last week that interest rates could hit 7% and that the world is not ready for that2.
While Mr Dimon was perhaps being a bit coy about the catalyst for rates rising further, Mr Dalio was explicit - the problem is fiscal dominance (large deficits increasing the cost of debt which in turn creates the need for more debt issuance, creating a negative spiral). Perhaps JP Morgan’s CEO was sounding a warning to the Treasury and Congress to get their act together with respect to fiscal probity, but with the current internecine strife in US politics, budget control seems a long way off. With no speaker in the house, keeping the government running beyond November would be an achievement at this stage.
The problem of fiscal dominance or crowding out is not something that has suddenly appeared out of nowhere (see my post from May this year below). The question isn’t how, if at all, and at what threshold of market stress the Fed intervenes this time around. The real problem is the consequences of an explicit easing move (however it is dressed up) on the Fed’s message about ‘higher for longer’ and what impact this will have on inflation expectations, the creditworthiness of the US and the dollar. This is when AZ-5 risks becoming a detonator not a kill-switch.
Fed Chair Jay Powell has been vociferous about sticking to the rate-tightening process, in part because he is making up for previous mistakes. Shifting to a flexible inflation target in 2020 then insisting that inflation was transitory in 2021 left the Fed well behind the curve in 2022, forcing it to play catch up aggressively. Stopping QT, restarting QE or even having to cut rates in response to a bond market crisis are currently at the very bottom of the Fed Chair’s to-do list, but events may yet prove to be moving beyond his control.
While there is much talk about a return of bond vigilantism at present, it may just be conventional buyers of Treasuries such as central banks, asset managers and other financial institutions, both foreign and domestic, who take fright if the Fed is forced to intervene in the bond market once again3.
Any perceived capping of yields before inflation is truly tamed would mean that the real return for bondholders, that is the nominal yield less inflation, could start to fall, reducing demand for Treasuries just at the point the US might be tipping into recession and therefore just at the point at which the US primary deficit would be expected to start rising as tax receipts fall and the automatic stabilisers of unemployment entitlements start to rise. Less demand, more supply, more need for Fed buying and so on - the definition of a debt spiral. The backdrop of a pre-recession US deficit already heading towards double digits even with unemployment near historic lows does not help at all.
Clearly the event, should it happen, will have to be a major one. The US stock market falling 10 or 20% probably won’t suffice. A major collateral problem or a rapid deterioration in the credit market (or both, and likely linked) due to a further sharp rise in bond yields might fit the bill. Heavy Treasury issuance (slated to be around $850b in Q4) isn’t helping, nor would a government shut down in November. External catalysts, such as the Bank of Japan being forced to sell dollars (and Treasuries) to defend a weakening yen, loom on the horizon.
In the event of a Fed intervention, the key factor to note will be whether the market just shrugs and says ‘back to the old regime’ of Fed intervention, recycling the cash into the equity market, buying tech stocks, rinse, repeat. If bond holders keep selling, yields may rise further (or real yields fall sharply), and this may be the point at which the dollar starts to weaken, either against the other major currency crosses or in terms of commodity prices (ie: the latter start rising). Rising yields and a falling currency are a very ‘emerging market’ look, and really not one the world’s reserve currency wants to have. Add a recession to the mix, and that would start to look decidedly ugly - a meltdown in the reactor core in fact.
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Bridgewater’s Ray Dalio warns of impending debt crisis in US, CNBC reports, Reuters, 28/09/2023.
Adam Clark, Jamie Dimon Warns the World It’s Not Prepared for 7% Interest Rates, Barron’s, 26/09/2023.
Edward Yardeni, Bond vigilantes threaten to run Biden out of town, Markets insight, Financial Times, 05/10/2023.