Tremors

With interest rates finally rising after a long period in which (at least according to some) they were at 4,000-year lows, there is bound to be a period of painful adjustment, and periods of painful adjustment rarely go smoothly in the financial markets. So far, to take a fairly random selection, we have seen an exaggerated response to the U.K.’s mini-budget (made much worse by the games that have been played with derivatives in the British treasuries, or ‘gilts,’ market), unease over Italian government bonds, emerging market woes, crashing stock markets, wobbly housing markets, and a great deal of (unhealthy) speculation surrounding two major European banks, Credit Suisse and Deutsche Bank.

The Economist has more:

On October 4th the IMF sounded the alarm about open-ended bonds funds, which hold $41trn in assets, a quarter of financial assets outside the banking system. Investors can sell their holdings once a day, “but it may take fund managers several days to sell assets to meet these redemptions, especially when financial markets are volatile,” warned the imf. That exposes them to moves in market pricing. Outflows are amassing. Investors have pulled 8% of their assets from these funds this year . . .

Measures of liquidity in the Treasury market have deteriorated . . . “We are seeing what happened in March 2020 again. The same Treasury bonds are trading at different prices, bid-ask spreads are widening,” says Darrell Duffie of Stanford University. Strategists at Bank of America describe their index of credit stress as “borderline critical” .

As so often when things start to go wrong, the unintended consequences of regulation make themselves apparent (this was certainly the case with the global financial crisis, although the appeal of blaming of that debacle on greedy bankers meant that overreaching regulators escaped much of the blame that should have come their way).

This time round, a culprit may be the way that tough regulation of banks has driven financial assets away to less closely supervised destinations.

The Economist:

In 2010, after the financial crisis, banks held $115trn of financial assets. Other financial institutions, such as pension funds, insurers and alternative asset managers, held roughly the same amount. In the years since, the non-banks’ slice has grown. By the end of 2020 they held assets worth $227trn, a quarter more than the banks. Similarly, four-fifths of American mortgages came from banks before the financial crisis. Today only around half do, and most of these are sold on to investors.

Thus the dodgy stuff is probably in other institutions. Which ones? In 2007 problems started in real estate. This time Americans have far less mortgage debt, but the sheer pace of price growth in residential housing suggests some buyers will face difficulties. Indeed, three-quarters of those who bought in the past two years regret their decision. Other forms of real estate are also vulnerable. Firms are downsizing their offices to adapt to working from home, posing problems for highly leveraged commercial developers. Charles Bendit of Taconic Partners, a developer in New York, notes that lots have opted for floating-rate debt, meaning their debt-servicing costs have already doubled.

Michael Burry, who shot to fame in 2008 after shorting mortgage-backed securities, is concerned by unsecured consumer finance given the growth of “buy-now-pay-later” providers and the ease with which consumers have been able to tap credit-card lines. Goldman Sachs, a bank, ventured into consumer credit in 2019, helping to launch the Apple card. It now has an unusually high default rate of 3% over the past six months. Ms Graseck of Morgan Stanley points out that, because this is an interest rate-shock driven cycle, trouble will probably first arrive in the loans that reprice to higher rates quickly: “Floating rate debt, like credit cards, is immediate, then commercial real estate, autos and eventually mortgages.” . . .

It is companies more broadly that appear most at risk. They owe debts worth 80% of GDP, compared with 65% in 2007. A third of American corporate debt is rated BBB, the lowest investment-grade rating. Firms downgraded any further are not eligible for many investors’ portfolios. Defaults are now arriving . . .

The article is paywalled, but if you have a subscription, it’s well worth reading in full.

It’s at times like this that it’s worth recalling those immortal words by Warren Buffett:

Only when the tide goes out do you discover who’s been swimming naked.

A lot of people, I suspect.

A rough ride seems on the cards. How the Fed and other central banks react will be . . . interesting.