A Suggestive Failure of Market Confidence

As the Federal Reserve formed its plan to raise interest rates at an increasingly aggressive rate over the last several months, it became clear that it would be disruptive to financial markets. This was particularly likely because there were, and remain, multiple assets and asset classes that were more vulnerable than others. What was far from obvious was that the United Kingdom sovereign bond market would be among them. Yet when the new government of Liz Truss announced plans to reduce certain taxes without adequate plans to pay for them, the markets revolted. The market in gilts reacted with a violence that was stunning for a market that historically benefited from a perception that the UK was one of the more reliable issuers of sovereign debt. The reaction was more like that of emerging markets than the bonds of a leading government.

It is thus worth exploring what this implies for markets in general. In a recent paper Claudio Borio of the Bank for International Settlements described a framework for thinking about the historical development of financial market behavior that places this episode in context. He describes a change in the genesis of economic contractions in the 1980s, in which inflation stabilized at ever-lower levels, relieving central banks of the need for sharp periods of monetary tightening. Lower inflation supported lower interest rates, which encouraged borrowers to expand their debt levels. The result, Borio observes, is that

Borio addresses the obvious question—will there be threats to financial stability again? He is confident that the banking system is stronger, benefiting from the regulatory responses to the GFC and, we would add, behavioral changes induced by that trauma. He is less confident in non-bank financial firms who have expanded in a post-GFC competitive vacuum left by the banks.

Prominent among those candidates are private markets, which have grown to somewhere in the vicinity of $10 trillion (note 1). This includes unlisted equity, private credit and venture capital. They have expanded at such a pace precisely because they are private, subject to more subjectivity in valuation and more out of regulators’ reach than public firms. Together they make private markets leading candidates for trouble.

Another threat to financial stability is the perennial candidate: real estate. Prices exploded during the Covid episode and its accompanying lifestyle changes. But those are now at levels that produce eye-watering increases in monthly payments on residential property in the US when current interest rates are applied. A 30-year mortgage rate has reached 7%, which applied to the rising median price of an existing single-family home produces a monthly payment that has doubled from the time the pandemic began. In such circumstances price declines, which have begun, are likely to continue. The extent of the damage will probably be attenuated this time by the post-GFC reduction in construction. But some contraction is highly likely in the presence of sharp increases in both price and interest rate.

The UK brush with fate showed that serious trouble can come out of nowhere in this environment. Financial markets’ confidence was perilously close to collapse even for a previously pristine borrower. Whether the market reaction was due to questions about the solvency of the government, which could have been a reaction to the failure to pay for tax cuts, or only a transitory loss of liquidity is a perfunctory distinction. The fact is that in the moment the market had a seizure.

It turned out that the only market maker that mattered was the most important bank of all—the Bank of England, which said it would buy up to £65bn of UK government bonds. From the Financial Times:

The BoE’s defense of the scheme, in which it said it would buy up to £65bn in gilts over a 13-day period, is the clearest sign yet of how close the UK came to a market meltdown following (the government’s) plan for £45bn in unfunded tax cuts. (note 2)

But like other major central banks the BoE was in the process of reducing its balance sheet by selling UK bonds. Such a U-turn was perceived as a surprise, but in fact was simply proof that central banks’ stated intentions to tighten policy in response to inflation was only as good as the current conditions allowed. In fact, urgency once again trumped importance and the central bank lender of last resort doctrine not only survived but prevailed.

The U.S. dollar has, at least so far, been a beneficiary of capital flight from capital markets’ fears elsewhere. But this does not guarantee that such confidence shall necessarily prevail. Treasury Secretary Janet Yellen, after making an October 12 speech in Washington, said that

This speaks loudly to the bigger question, which is the latitude that central banks have to return inflation to low single digits. The Federal Reserve is steadfast in keeping to their 2% target. But high debt levels and tightening financial conditions do not make traveling companions for long. The UK experience is not encouraging.

1. Financial Times, August 12, 2022
2. Financial Times, October 7, 2022
3. Bloomberg, October 12, 2022

Reference

Borio, Claudio, Monetary policy: past, present and future, Bank for International Settlements, September 8, 2022.