Perspective on Risk - Sept. 29, 2022 (The Pain Has Only Begun)
The Pain Has Only Begun; Kashkari Says Higher Rates Are Here To Stay; CBs Preparing For The Next Crisis
The Pain Has Only Begun
Let’s all remember that the Fed has only this month begun to unwind it’s balance sheet at its full rate.
Overseas dollars are coming home.
So far:
Japan Intervenes to Support Yen for the First Time Since 19981
Chinese Remembi is under considerable pressure. If the USD strength continues they may need to revalue more rapidly.2
The GBP has blown up and the BoE has intervened as UK pension funds have faced collateral calls on the FX swaps done on non-sterling assets they have purchased.
UK pension plans are also facing collateral calls associated with “liability-driven investment” which is driven by MTM accounting regulations. This might even be the bigger driver of the BoE actions. Essentially duration matching of assets and liabilities. You can learn more by reading Hiking Beyond When Something Breaks3 and The reason the BoE is buying long gilts: an LDI blow-up (FT)4.
Korea, India and Indonesia have all intervened to support their currencies.5
Some companies are announcing earnings ‘misses’ due to foreign currency translation
The US Aggregate bond market is experiencing one of its worst periods ever.
US equity markets are now officially in a bear market (as opposed to a correction)
Demand for USD Treasury collateral is rising, as witnessed by the declining term risk premium.
Financial conditions are now tight (I believe this is the GS Financial Conditions Index) and getting tighter.
Things that are happening, but are not yet observable:
Residential house prices are collapsing.
This means that many mortgages originated in the last two years have considerably more loss potential should the borrower default. We are facing a 1981-level mortgage shock.
I imagine other EM countries are facing considerable pressure due to the dollar strength.
The probability of a recession has risen considerably.
Borrowing costs for corporates and commercial real estate have, or will begin, to rise, particularly as refinancing needs come forward. For example, from 1992-2008 CRE cap rates averaged 262bp above 10 yr UST, and ranged from 100bp to 425bp over. Cap rates in the 6-7% range will require massive restructurings of the capital stack.
Minsky characterized companies where “the cash flows from operations are not
sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations” as ‘ponzi units’.6 These would include numerous startups, SPACs and other highly-leveraged, low-rated (B, Ccc) companies. We will see many of these fail.
Kashkari Says Higher Rates Are Here To Stay
The question becomes:
Will the Fed blink when things break?
Well, the Reserve Bank President without a filter, Neel Kashkari stated:
CBs Preparing For The Next Crisis
I missed this when it first came out. Fortunately, Dan Davies caught it and the FT ran a post about it. Setting the stage for the document, Davies writes:
Ever since the Great Financial Crisis, economists like Perry Mehrling have been arguing that we need a “New Lombard Street”, because the Federal Reserve, Bank of England, European Central Bank and the rest have steadily taken on a role as “dealer of last resort” when securities markets threaten to blow up.
The BIS Markets Committee issued “Market dysfunction and central bank tools: Insights from a Markets Committee Working Group” which was co-authored by Lori Logan (at the time on the FRBNY’s Markets desk) and Andy Hauser of the Bank of England (Executive Director for Markets). The Markets Committee “monitors developments in financial markets and their implications for central bank operations.” It publishes infrequently and doesn’t get the headlines that the Basel Committee on Banking Supervision does.
When this Committee talks, and when Logan and Hauser author a paper, we should pay attention.
Some of this sounds uneventful, such as when they write:
In light of these considerations, the Markets Committee has assessed that the key overarching principle for central bank interventions aimed at restoring market functioning is that they should act as backstops. That means on the one hand, in situations where it appears likely that market dysfunction will have a material adverse impact on the real economy, central banks should consider using their ability to expand their balance sheets and provide liquidity in order to mitigate this impact. On the other hand, it means that central banks should aim under normal market conditions not to (i) interfere with price discovery or market determination of the allocation of resources; or (ii) substitute for the primary obligation of market participants to manage their own risks, reinforced through appropriate macro- and micro-prudential regulation and supervision
Davies suggests:
This looks like it could form the basis for a quite activist policy; it would suggest that central banks did the right thing in March 2020, when they flooded the market with liquidity to prevent bond markets locking up at the start of the COVID pandemic.
He’s probably right, though by writing this explicitly they are at least acknowledging that their efforts may have gone beyond the traditional bounds of Bagehot.7
Andrew Hausar gave a speech in January with the extremely long title From Lender of Last Resort to Market Maker of Last Resort via the dash for cash: why central banks need new tools for dealing with market dysfunction that perhaps expands a bit on their thinking.
He writes:
Increasingly we look to financial markets, rather than banks, to care for our savings or provide credit. … [F]ully half of all financial assets are now held outside the banking system.
[M]arket-based finance seems increasingly prone to liquidity shocks. Some of that reflects vulnerabilities in business models and practices of specific market participants: including liquidity mismatch in funds; leveraged and trend-following investment strategies; or insufficiently forward-looking margining practices. But it also reflects a growing imbalance between the size of key markets, and the balance sheet capacity of banks and dealers who have traditionally helped transfer risk smoothly between investors and borrowers
It is unsurprising that the initial wave of lockdowns last Spring caused a surge in demand for precautionary liquidity. But the implications of that shift were greatly amplified by a breakdown in the functioning of markets core to the maintenance of monetary and financial stability.
To avoid an even deeper economic collapse, the functioning of these markets had to be restored rapidly. And that was achieved through swift and decisive central bank action, using large-scale asset purchases and other tools capable of tackling both the economic shock and the market dysfunction.
Concluding:
This was an appropriate response to a truly unprecedented situation
What is more interesting is what follows; this I imagine will be the basis for a BIS workplan:
If financial markets are to support the increasing reliance placed on them safely, we must do more to reduce the scale of inherent vulnerabilities ex ante, and build better-targeted tools for dealing with financial instability caused by market dysfunction ex post. And that, in turn, requires work in three separate but self-reinforcing areas
ensuring that non-banks active in financial markets are more resilient to future liquidity shocks
strengthening market-wide infrastructure
Better targeted central bank backstops
He then goes on to elaborate how central banks can perform the expanded role of “providers of public liquidity insurance,” describing some of the dimensions and questions that must be answered. In many ways, this is a revisit of the traditional discount window questions. In many ways, as he acknowledges, many of these questions have been preliminarily answered as central banks have dealt with crisises back to the GFC (or maybe even earlier).
This table or responses to Covid was interesting:
Fujioka, Nohara, and KondoJapan, Intervenes to Support Yen for the First Time Since 1998, Bloomberg
Chu, Exclusive-China's state banks told to stock up for yuan intervention-sources, MSN
Kelly, Hiking Beyond When Something Breaks, Without Warning Substack
Nangle, The reason the BoE is buying long gilts: an LDI blow-up, FT
Horta e Costa and Kim, Plunging Markets Spur New Intervention Warnings Across Asia, Bloomberg
Minsky, The Financial Instability Hypothesis
Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified.
Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit.
Speculative finance units are units that can meet their payment commitments on "income account" on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to "roll over" their liabilities: (e.g. issue new debt to meet commitments on maturing debt). Governments with floating debts, corporations with floating issues of commercial paper, and banks are typically hedge units.
For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.
Bagehot once wrote
Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.
More commonly, this has been written as “Lend without limit, to solvent firms, against good collateral, at ‘high rates’.”