The 2022-23 Economic Crisis Megathread

[Tamas]

The US market rallied in August because there were indications inflation was not going to be as high as forecast, therefore the Fed would not have to hike as much.

Powell "found his balls" when these indications proved to be false and inflation did in fact stay high.

A hike of 50 bips instead of 75 is not "a new round of money printing."  It's less contractionary than had been expected.

0.50 vs 0.75 would not create a big month-long bear market rally. It was clear -I have been told, won't pretend I figured this on my own- that the bond markets at the time (back around June/July already I think) priced in the Fed stopping with hikes around November/December and then decreasing the interest rate quite early in 2023. THIS expectation of a Fed pivot that drove the rally in all likelihood, and this expectation was disproven first by Powell's Jackson Hole speech and then later by the last 0.75 hike and the uncharacteristically clear messaging in both occasions that they are still targeting a 2% inflation and will keep at it until they achieve it.

The bond market expectations changed radically after those two speeches and the rate decision, as I understand, and they are (or rather, until today were) moving to accept the Fed promises as truths as opposed to bluffs.

The madness today around and after the Bank of England decision shows me that significant forces still expect to see this Fed pivot, or at the very least want to play along people who do. The market turnaround happened exactly on the BoE announcement. Funnily enough I think the FTSE100 remained kind of flat.

[celedhring]

Spain's early inflation data shows a record drop from its record high of 10.5%, to 9%. Mostly because of energy prices (although other products also drop a little). Hopefully it's the same for the rest of the EU...

[Iormlund]

So, what the Hell is going on with Credit Suisse and Deutsche Bank?

[mongers]

So, what the Hell is going on with Credit Suisse and Deutsche Bank?

Likely financing arms sales to Putin.

[Sheilbh]

Then today, in comes the Bank of England, announcing what amounts to renewed Quantitative Easing: purchase of government bonds to stop yields from going to the moon.

Just a bit on this - this isn't quite right.

The issue wasn't yields themselves. The issue was pension funds. Obviously they hold vast amounts of government bonds. In general it is a good thing for them to see bond yields go up because they need to hold fewer to get the income they need.

But the increase in yields caused them an issue because, as sensible financial institution, they'd hedged their position against yields falling. In addition, obviously, they're holding foreign government bonds which are also hedged (including forex hedging). From what I understand the yield rise wouldn't have been an issue for them if it took place over a few months because they could unwind positions and adjust. Because it was so rapid, from what I've read, they were facing margin calls on very different positions and the BofE intervention was because there was a fear that there just wasn't enough liquidity and that massive pension funds would go under facing these margin calls. They'd end up in a vicious cycle of selling off bonds to meet demands for cash immediately which would put them at risk. It was explicitly to "restore orderly conditions" for pension funds.

The interesting (alarming) thing is that from what I've read the Treasury wasn't aware of this risk within the financial system and neither was the BofE until it materialised - it's not clear any other central bank was either. Which just makes you wonder what other risks are baked into the financial system that we're not yet aware of and neither are the central banks. One banker the FT quoted said "it was not quite a Lehman moment. But it got close." The issue wasn't to stop gilts rising in and of itself but stopping a risk of massive asset-holders going under.

Particularly striking because, I've mentioned before, but on OECD/IMF comparsions the UK rates really well on its pension system because there is such a large sink of pension assets (I think about 100-150% of GDP) - but in the safety of having that across multiple big funds it's perhaps more exposed to something like this? And who is the beneficiary of what is effectively a massive bail-out by a techocratic wing of government which isn't subject to democratic control in a private meeting one day?

[Tamas]

Yeah rising yields mean the bonds are losing value so I meant what you explained in detail.

Allegedly it is normal for these funds to do 100 to 1 leverage deals on those bonds because of how stable they used to be. So when they started doing wild moves the funds were looking at margin calls they couldn't hope to pay at the days' close.

[The Minsky Moment]

The interesting (alarming) thing is that from what I've read the Treasury wasn't aware of this risk within the financial system and neither was the BofE until it materialised - it's not clear any other central bank was either.

That's an extraordinary statement. That isn't seem obscure risk tucked into a shadowy corner of the financial system.  It's a very common risk in the hands of the largest holders of assets.

[Sheilbh]

That's an extraordinary statement. That isn't seem obscure risk tucked into a shadowy corner of the financial system.  It's a very common risk in the hands of the largest holders of assets.

In which case perhaps the question is more what other systemic risks do policymakers not really comprehend because they perceive it as basically de-risked, or, perhaps, what other risks they choose to ignore until they are forced to intervene?

Relatedly I suppose you have to wonder if that's a good way to run the financial system where there are these very common risks built into the financial products we all rely on (pensions and mortgages especially), but we are "safe" because the (non-democratic etc) central banks will act as the fire brigade. I feel like you'd hope that was somewhat addressed 15 years after the financial crisis - I'm not sure it is (perhaps it is in banking itself with ring-fencing, stress tests etc)?

[The Minsky Moment]

At risk of stating a truism, if you are going to have a financial system based on an ample supply of a low-risk financial asset, then policy has to be oriented around de-risking that asset.

Because of the dollar's unique role in the international financial system, the US has been able to get away with some degree of fiscal flexibility without causing too much disruption to the treasury securities market.  But sterling has not been in the same position since the era of jodhpurs and pith helmets.

A key weakness of the Trumpian flavored neo-Thatcherism now in vogue with some Tory Party cadres is the same weakness that has infected British policymaking for decades - the failure to recognize that ends are limited by means.  Muggings by reality do not discriminate between political camps.

[Sheilbh]

Because of the dollar's unique role in the international financial system, the US has been able to get away with some degree of fiscal flexibility without causing too much disruption to the treasury securities market.  But sterling has not been in the same position since the era of jodhpurs and pith helmets.

For sure - although in the case of the UK (and the rest of Europe in my view) part of the story here is high debt, low growth and austerity in a decade of exceptionally low interest rates. It's striking that the political consequences/perceptions for a failure to follow market signals only seems to work one way.

I'm very critical of Truss and Kwarteng - I'm not thrilled at the sight of people on liberal/left side of the debate becoming quite such market fundamentalists because it strengthens their argument at this moment. I think part of it was the substance but maybe not as much as the brash style of trying to be seen to "do something", doubling down, dismissing concerns etc (and now u-turning). I genuinely wonder what the reaction would have been if, except for the energy support package, this was all announced in the normal budget in April, I think it would have been significantly less volatile (though low liquidity also didn't help). I think in large part it was credibility more than anything actually substantive.

I think there is a case to be made for the some of the supply side reforms Kwarteng talked about in his budget. But he's shot his credibility (and his PM's) so there's no chance of passing them. It's a bit like a political version of a doom loop

A key weakness of the Trumpian flavored neo-Thatcherism now in vogue with some Tory Party cadres is the same weakness that has infected British policymaking for decades - the failure to recognize that ends are limited by means.  Muggings by reality do not discriminate between political camps.

Out of interest how do you think that weakness was reflected in, say, the Cameron, Blair or Major years? I can see an argument on Blair's foreign policy but less clear on Cameron, Major - or Thatcher for that matter.

Having said that I'm not sure that's really what was going on that it was a judgement by the markets on the fundamentals. Almost everything had been pre-briefed before the panic and I just struggle to believe that the surprise elimination of the 45% rate at a cost of £2 billion caused that much more of a reaction than the energy support package worth 6% of GDP (announced two weeks prior) or the other £43 billion worth of tax cuts/unwinding tax rises implemented by Sunak in April that been pre-briefed.

I also didn't think there was any real Trump flavour to Johnson, but there's even less to Truss. I can't honestly think of a single Trumpian feature of Truss.

[Tamas]

https://asiatimes.com/2022/10/global-margin-call-hits-european-debt-markets/

NEW YORK – Risk gauges in Germany's government debt market rose last week to levels higher than recorded in the 2008 world financial crash, as margin calls forced the liquidation of derivatives positions held by banks, insurers and pension funds.

Big institutional investors that spent the past ten years insuring their portfolios against falling interest rates now face massive losses as hedges blow up. A key measure of market risk, the spread between German government bonds (Bunds) and interest rate swap agreements jumped above the previous record set in 2008.

The cost of hedging German government debt with interest-rate options, or option-implied volatility, meanwhile rose to the highest level on record.

The blowout in the euro derivatives market follows a near-collapse of the British government debt, or gilts, market, averted at the last minute by a 50 billion pound bond-buying spree by the Bank of England.

The world's central banks responded to the 2008 world financial crash and the European financial crisis of 2011 by pushing bond yields down.

"Real" yields, namely the yield on inflation-indexed government bonds, went deeply into negative numbers in Germany and the UK, followed by the US market. That pulled the rug from under insurance companies and pension funds, which invest pension payments and insurance premiums to provide for future income.

To compensate, European and UK institutions locked in long interest rates with derivative contracts, or interest-rate swaps, that receive a long-term interest rate while paying a short-term interest rate. Swaps are a leveraged position that requires collateral worth a fraction of the notional amount of the contract.

When the Fed jacked up interest rates in late 2021, the value of interest rate swaps that pay fixed and receive floating imploded. Pension funds and insurers were stuck with the equivalent of a ten-to-one margin position in long government bonds. The price of long government bonds fell by nearly 20% across the Group of Seven countries, and the value of derivatives contracts evaporated.

That left the institutions with margin calls that they could meet only by liquidating assets. That in turn led to a run on the UK government bond market, followed closely by the rest of European bond markets. The Bank of England's emergency bond-buying delayed a market crash, but the UK gilts market remains on a knife edge, with option hedging costs at an all-time high.

A portfolio manager at one of Germany's largest insurance companies said, "It's a global margin call. I hope we survive."

Weaker European banks may have trouble finding short-term funding. The cost of credit default swaps that insure 5-year bonds of Credit Suisse is now higher than it was in 2008, at nearly 400 basis points (4 percentage points) above the cost of interbank funding.

The venerable Swiss institution is a special case, with a series of losses due to poor risk controls. Credit Suisse probably will survive – bank regulators will force it to sell assets and shrink – but it will also call in collateral from customers.

American pension funds and insurers haven't faced the same kind of margin calls, but they stand to suffer painful losses. As interest rates fell, they shifted to real income-earning assets like commercial real estate. The value of commercial real estate investment companies on the US stock market has fallen by 35%, about the same amount as the tech-heavy NASDAQ Index.

If that's any indication, the $20 trillion value of the commercial real estate market has lost about $7 trillion this year, in addition to losses of nearly 20% on corporate bond and stock portfolios.

Stocks and bonds, the largest components of pension portfolios, are down about 20% during 2022.

European stocks are down 30% in dollar terms, and Japanese stocks are down by 25%. The publicly traded stock of private equity firms like Blackstone and KKR has lost 35% during 2022 to date.

All in – depending on which survey of pension fund asset allocation you believe – the average US pension has probably lost more than 20% of its asset value this year.

The Fed-driven asset bubble of the past ten years brought US pension funds up to minimum funding requirements to meet liabilities as of 2021. Now the Fed may take it all away again, and the biggest problem for major US corporations may be unfunded pension fund liabilities.

[The Minsky Moment]

Out of interest how do you think that weakness was reflected in, say, the Cameron, Blair or Major years? I can see an argument on Blair's foreign policy but less clear on Cameron, Major - or Thatcher for that matter.

I don't think it applies to any of them, even Blair who was careful to maneuver under the wing of American hard power (but not careful enough to consider the limits of that power).  It's more a throwback to an older era, a kind of minor league financial Suez.

I also didn't think there was any real Trump flavour to Johnson, but there's even less to Truss. I can't honestly think of a single Trumpian feature of Truss.

I don't think it's a feature of her personally, rather it's a leakage of American style polarized rightwingery into the Tory Party ranks.

[Sheilbh]

I don't think it applies to any of them, even Blair who was careful to maneuver under the wing of American hard power (but not careful enough to consider the limits of that power).  It's more a throwback to an older era, a kind of minor league financial Suez.

I'd be a little harder on Blair because I think he over-promised to the Americans on what Britain/he could do as an ally - especially in Iraq and Afghanistan where, bluntly, British forces lost and often had to be bailed out.

Agree on a minor financial Suez - I think conditioned more by the last ten years of extremely low interest rates and an ideologically driven misunderstanding of what markets want.

I don't think it's a feature of her personally, rather it's a leakage of American style polarized rightwingery into the Tory Party ranks.

Although that doesn't work without an American style polarised society - as we're seeing in the public response to this (including among Tory voters), but also as we saw in the response to Johnson's scandals (over, by Trump standards, exceptionally minor indiscretions - breaking covid rules) and covid more generally. More fundamentally I don't think Britain has a political environment where opponents are enemies or where loser's consent has been eroded as it has in the US - and I don't think that's happening.

My own take on the last few years of British politics is that Trumpian politics was really a feature of the Corbyn project more than anything that's been going on in the Tory party - that was just standard Tory nonsense.

Tamas - interesting and worrying but it feels like there's a real disconnect with the real economy (especially in the US). And one of the big challenges for policymakers is surely narrowing the gap between the two?

[Tamas]

Tamas - interesting and worrying but it feels like there's a real disconnect with the real economy (especially in the US). And one of the big challenges for policymakers is surely narrowing the gap between the two?

Yeah. One thing I have found incredible as I have been mentioning is that the current financial system has resulted in the US stock market actively hoping for an economic downturn, just so they could get QE back. The BoE announcement launched a violent (altough to be fair only a day or two long) US rally.

I think in a decade or two the 2008-2022 (or who knows how long) period will be looked back at as one crisis. The emergency rates of (near) zero were kept way too long and now the resulting system cannot react to the unexpected schocks without getting close to breaking and I think it is going to break, just not sure how profoundly.

[Syt]

On the plus side, I will get a one time payment for increasing inflation (EUR 250), and a one time payment for increasing energy prices (EUR 250 from the government).

(I'm not eligible for the EUR 120 energy bill voucher, because my salary is too high )

So there's two ways people get sent the money:
1. if the federal revenue service has your bank details you get it sent to your bank account
2. if they don't have it they send it as vouchers that you can use in shops or cash in at post offices

I received a tax refund in July, and I checked online that they have my bank details.

So obviously I have a notification in my mail box now to pick up the vouchers at the post office.