The global financial system is in trouble

“But I’m not going to step in and try to fix the pumpkin market. So that’s the kind of thing wired with cash. It’s really saying that no one is willing to pay the price you are asking. Alright, that’s fine, just lower the price.

It must be said that the financial markets are a little more complicated than the pumpkin market on Halloween. They are influenced by regulation, by sentiment, by risk appetite, by the capacity of participants, and by very complex and opaque relationships between markets and different securities, among other influences.

The Bank of England was forced to intervene in the UK bond market last month to avert a currency and bond market crisis.Credit:PA

A demand problem is developing in global bond markets and particularly in the United States, where the Fed is conducting the most aggressive monetary policies.

It has raised rates by 3 percentage points since March, with at least another 1.5 percentage points to come, and helped its holdings of nearly US$9 trillion ($14.3 trillion) to US bonds and mortgages to decline as the securities mature.

This “quantitative tightening” (QT) began by allowing $47.5 billion of bonds and mortgages to mature without reinvestment on the proceeds in March, but was increased last month at a rate of $95 billion a month.

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The Fed was, and has been for most of the period since the 2008 financial crisis, the biggest buyer of US government bonds and mortgages and ended its quantitative easing programs by holding about a third of each market. It now buys about $60 billion a month less Treasuries than before its pandemic-related QE program ended in March.

He is not, however, the only former buyer to have reduced his appetite for Treasuries.

China, Japan and other governments have stopped buying or started selling some of their holdings in response to rapid increases in yields and consequent losses in bond market values ​​(bond prices fall when yields increase). Governments also sell US dollar assets, usually Treasury bills, in an attempt to limit the extent to which their currencies depreciate and import inflation and instability in the face of major US dollar appreciation.

Commercial banks have also reduced their holdings by about $70 billion since March.

The Fed has already withdrawn about $180 billion of demand from the market and is targeting a reduction of more than $2 trillion from its balance sheet over the next two and a half years. Foreign governments have reduced their holdings by about $50 billion in the past six months and this rate could accelerate, given the strength of the dollar.

Fed Chairman Jerome Powell.  Central banks around the world remain locked in a fight against inflation.

Fed Chairman Jerome Powell. Central banks around the world remain locked in a fight against inflation. Credit:PA

The US Treasury market is a $25 trillion market, and in normal times it is stable, with abundant liquidity. At present, however, it is more volatile than it has been in decades and shallow – large exchanges have outsized price impacts – and therefore less of a global haven for capital than it is. has not been historically.

A key question, given that the US Treasury must continually tap the market when rolling over or raising new debt, is who will replace reduced demand from the Fed and foreign governments?

Another question is whether volatility and reduced market liquidity could lead to the kind of unexpected financial system events seen in March 2020 or in the UK last month.

A factor in the volatility of a traditionally low volatility market is the post-2008 banking capital and liquidity reforms which have diminished the role that banks and investment banks now play as brokers responsible for creating a orderly market.

The aspirations of the Fed and other central banks for a smooth shift from QE to QT to combat runaway inflation rates may not be, as the BoE has so bluntly discovered, as easy to execute as they hoped or anticipated.

Another, given the role Treasuries play as benchmarks for other asset classes, could be the linkages between different markets and securities.

In the post-2008 environment of ultra-low to negative interest rates and abundant liquidity, the use of leverage by non-banks to amplify otherwise meager returns was alluring, whether by using debt or derivatives.

Post-2008 financial sector reforms have forced most derivatives transactions to move away from private agreements between principals and towards platforms operated by central clearing houses that require collateral.

The drastic change in bond market conditions this year could, as we have seen in the UK, force institutions to shed high-quality collateral (such as Treasury securities) to meet margin calls on other markets that are just as, if not more, volatile.

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Volatility in global bond, equity, currency and real estate markets could trigger – or trigger – margin calls that flow back to bond markets.

The liquidity problems in the bond markets that traders are complaining about – and the demonstration provided by the British experience – indicate that financial markets and systems are fragile and vulnerable.

The aspirations of the Fed and other central banks for a smooth shift from QE to QT to combat runaway inflation rates may not be, as the BoE has so bluntly discovered, as easy to execute as they hoped or anticipated.

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Don F. Davis