Financial markets showing new strain of coping with rate hikes

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The stunning political death of British Prime Minister Liz Truss shows what can happen when ambitious plans collide with a new financial market reality that prioritises the fight against inflation above all else.

Truss resigned Thursday after just 45 days in office, a victim of the market turmoil sparked by her plans to increase the national debt and cut taxes despite an annual inflation rate of over 10 percent.

The truss implosion was fueled by clearly British considerations. But the market turmoil – which at one point saw investors see the UK as a worse credit risk than notoriously profligate Italy – sparked unexpected difficulties for UK pension funds and began searching for the next financial domino that could topple as interest rates rise.

Mutual funds for bonds, pensions, corporate bonds and government finance are all being scrutinized for hidden weaknesses, analysts say, as the Federal Reserve continues to raise interest rates at its fastest rate in 40 years. Investors expect the central bank to hike interest rates several times over the coming months to cool rising consumer prices, including at its next meeting in November.

“The Fed will just keep wandering until something breaks,” said Eric Robertsen, global research director and chief strategist at Standard Chartered Bank in Dubai. “I think it’s more likely that there will be a financial market crack before there is an economic crack.”

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After years of easy-money policies, the Fed is leading central banks in tightening credit to fight painfully high inflation. Interest rates have risen sharply in the United States, the United Kingdom, Europe, Canada and dozens of smaller countries in the broadest campaign of its kind to hit the global economy in a quarter century.

Bond market volatility this month hit the highest level since early March 2020, when the Fed was forced to step in and buy $1 trillion in US Treasuries. Sluggish trading in Treasury bonds – typically the most liquid market in the world – is now prompting Treasury Secretary Janet L. Yellen to buy back some Treasury bonds from dealers to help the market function.

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Market grind does not mean an imminent financial crisis, analysts said. But the tensions illustrate the bumpy transition the global economy is making from more than a decade of ultra-low interest rates to an era of more expensive credit. With the Fed promising more rate hikes for months to come, further market volatility is likely.

Global stocks have lost around $30 trillion in value so far this year, while bonds have endured one of their worst years on record.

The financial rebalancing comes as international risks multiply, with the war in Ukraine and deteriorating US-China relations rattling markets.

Unpredictable connections between finance and geopolitics have flared up in earlier eras, such as in 1998 when the hedge fund Long-Term Capital Management collapsed during the Russian financial crisis, necessitating a US government-led bailout.

“There is a risk of a disorderly tightening of financial conditions, which can be exacerbated by vulnerabilities built up over the years,” the International Monetary Fund warned this month in a report that said risks to financial stability had risen since April and are continuing “significantly distorted”. the disadvantage.”

For more than a decade, while interest rates were low and the Fed was actively buying government and mortgage securities, investors found it easy to sell most assets.

Now that the Fed and other central banks are tightening monetary policy, normally liquid markets are becoming congested. Investors looking to sell a government bond, for example, encounter lags or large gaps between their asking price and what buyers will pay.

Because US government-backed securities are considered risk-free, their price is key to determining the value of other financial assets. So problems in buying and selling government bonds can infect other markets.

“Liquidity has masked weaknesses in other markets and now we will see what they are. And we’re going to see it across a range of assets,” said Megan Greene, the Kroll Institute’s chief global economist.

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While Truss took a beating in the UK for presenting a risky economic plan that had not been verified by independent analysts, UK pension funds became the focus of the crisis.

Many fund managers had opted for a strategy called liability-driven investing (LDI), which was supposed to enable higher returns on bonds in the low-interest-rate phase after the financial crisis of 2007-2008. With LDI, fund managers would essentially lend bonds for cash, which they would reinvest to increase returns.

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As UK government bond yields soared, the funds were forced to quickly raise cash to make up the difference between the original value of the bonds they were pledging and their current lower price.

The quickest way to raise money was to sell government bonds. But that set off a vicious circle: falling bond prices meant calls for more collateral, which required more bond sales and drove prices even lower.

“Those are the things that we’ve seen in the financial crisis and that’s something to worry about,” John Waldron, Goldman Sachs’ president and chief operating officer, told an industry group this month. “We don’t know what the next risk is that will move the market.”

Indeed, new problems elsewhere could bounce from market to market.

For example, companies with poor credit ratings could be downgraded to junk status, which would force some portfolio managers to sell their bonds, Greene said.

If these corporate bonds fall in value, other investors who bought them with borrowed money could suddenly face redemption demands. To raise money to meet those “margin calls,” they would sell other assets, triggering a price drop there as well.

Companies that already have low credit risk find it harder to raise money in the bond market. According to the Securities Industry and Financial Market Association (SIFMA), issuance of new high-yield, or “junk,” bonds is down three-quarters so far this year from the same period last year.

But only 19 percent of corporate debt that needs to be refinanced by the end of next year is junk, says Torsten Slok, chief economist at Apollo Global Management.

“The amount to be refinanced is quite manageable. The question is: how long will interest rates stay high?” said Slok.

If interest rates stay high, companies and governments alike would feel a serious pinch.

In previous episodes of market turbulence, the Fed often intervened to effectively stem the bleeding. In March 2020, as stock prices plummeted and Treasury trading faltered, the Fed cut interest rates to near zero and added more than $4 trillion in securities to its balance sheet.

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But with inflation now stubbornly high, the Fed is unlikely to be able or willing to cut rates or flood markets with cash, analysts said.

“We are in an unprecedented migration cycle globally. … I’m more nervous about the system collapsing because the Fed backstop just isn’t there,” said Priya Misra, head of global rates strategy at TD Securities.

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After the British debacle, higher interest rates are already overshadowing public finances. Despite highly indebted countries like Italy rising energy costs may need to downsize their borrowing plans. Already, 19 developing countries have to pay 10 percentage points more than the roughly 4 percent the US government is now paying investors over 10 years, according to the UN Development Programme.

Government bond markets may have become more vulnerable to shocks over the past decade, according to a new report from the Financial Stability Board, a global advisory body.

Trading in the US Treasury market is less liquid than it has been since April 2020, according to a Bloomberg measure.

The market congestion is the result of the sharp increase in the volume of sovereign debt coupled with the impact of post-financial crisis regulations, which were intended to make banks safer but have also made banks less willing to hold sovereign debt on their own books You are looking for a buyer.

Outstanding government bonds of $23.7 trillion have risen by more than $7 trillion since the end of 2019, according to SIFMA, reflecting the cost of battling the pandemic and supporting the economy.

At the same time, regulations enacted in the wake of the financial crisis require banks to hold more capital in reserve to cover potential losses on securities they own.

The Fed has also stopped reinvesting the money it receives from maturing securities, which some investors say has hurt demand for Treasuries.

The Treasury Department this month asked traders whether they support a potential program for the government to buy back some securities and, if so, how it should be structured.

“We are concerned about a loss of sufficient liquidity in the market,” Yellen said this month.

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