LONDON, Oct 6 (Reuters Breakingviews) - Great bull markets are propelled by a dominant belief: a “new era” of permanent prosperity, an exciting new technology, and so on. Bear markets occur when that belief is proven wrong. The severity of the downturn depends on how wrong the previously bullish notion turned out to be. The false idea exposed by the current bear market is that interest rates would remain low indefinitely. That’s turned out to be a colossal mistake.
Consider some of great financial errors over the past 25 years. The Asian crisis erupted once it became clear that Southeast Asian “Tiger” economies were on an unsustainable development path. The dotcom bust revealed that earlier forecasts for growth in internet traffic were too optimistic. The global credit boom in the early years of this century ultimately rested on the widespread belief that American home prices would never decline. The subsequent meltdown triggered the euro zone debt crisis which exposed another false belief, namely that sovereign credit risk in the single currency area was a thing of the past. These crises reveal a disturbing trend: each successive market collapse has tended to generate greater financial losses over a greater geographical reach than its forerunners.
The belief that interest rates would remain at permanently low levels could prove the most costly error of all. That’s because, as the former Federal Reserve governor and Harvard economist Jeremy Stein commented a decade ago, “monetary policy gets into all the cracks.” Over the last decade, easy monetary conditions transformed the world’s financial markets and economies. Seth Klarman, the Boston-based hedge fund manager, wrote early last year: “The idea of persistently low rates has wormed its way into everything: investor thinking, market forecasts, inflation expectations, valuation models, leverage ratios, debt ratings, affordability metrics, housing prices, and corporate behavior.”
The great American economist Irving Fisher declared that interest is an “omnipresent phenomenon”. The lowest-ever interest rates gave us the “Everything Bubble”. Now that interest rates are rising, everything is at risk. Since the start of this year, major global bond and stock market indexes are down more than 20%. Regional real estate markets from Australia to China are cracking. Meanwhile, 30-year U.S. mortgage rates have doubled since January and British lenders are rapidly repricing their home loans.
As the Fed tightens monetary policy to restrain U.S. inflation, the dollar has soared against other currencies. That has upset the calculations of foreigners who borrowed trillions of dollars at low rates. Domestic carry trades are also unwinding. Many leveraged loans are trading well below par, high-yield bond spreads have widened, private equity buyout deals are creaking, and corporate mergers have ground to a halt.
These responses are painful but not completely unexpected. If interest rates are to valuations what gravity is to matter, as Warren Buffett maintains, then it was always likely that asset prices would fall when the cost of borrowing eventually picked up. In the terminology made famous by former U.S. Secretary of Defense Donald Rumsfeld, these consequences count as “known knowns”.
However, investors also confront a series of “known unknowns”. The recent turmoil in the UK government bond market belongs in this category. The period of low rates proved particularly challenging to British defined-benefit pension funds. According to current accounting standards their reported liabilities increase as bond yields fall. Large pension funds sought to hedge against the prospect of falling rates with a strategy known as liability driven investment (LDI). This involved acquiring long-dated government bonds whose maturities matched future expected payouts.
The idea was that if interest rates rose, future liabilities would decline in tandem with bond prices, and the pension funds would be no worse off. The wrinkle was that, rather than buying gilts, many funds gained much of their exposure through interest-rate swaps. Furthermore, they applied leverage by borrowing against shorter-dated bonds. But as expectations of future interest rates rose quickly, gilt prices cratered. At the end of last month one inflation-indexed government bond maturing in 2073 was down 85% from its peak just 10 months earlier. The pension funds faced margin calls on their loans, and the bond market seized up as they scrambled to raise cash.
In some respects, this debacle resembles the failed portfolio insurance strategies that triggered the October 1987 stock market crash. In both cases, market liquidity dried up just when it was urgently needed. A few astute observers had spotted the flaw at the heart of LDI. Simon Wolfson, the head of UK retailer Next (NXT.L), says he warned the Bank of England of this potential “time bomb” five years ago.
The great “unknown unknown” is how the broad derivatives complex, which has notional positions measured in the hundreds of trillions of dollars and incorporates unfathomable leverage, with the vast majority linked to interest rates, will react as borrowing costs rise from their lowest levels in history.
This episode demonstrates how, after years of easy money, the global financial system is acutely sensitive to rate hikes. It also points to regulatory shortcomings. For years, central bankers maintained that monetary policy should be separate from so-called macroprudential regulation – the management of financial risks. The trouble is that, as Jeremy Stein understood, regulators were always likely to be behind the curve as market participants eagerly sought to enhance returns. Just as the losses at Bear Stearns’ hedge funds in June 2007 signalled the onset of the financial crisis triggered by U.S. subprime mortgages, the gilts crash provides a warning of more problems to come.
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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own. Refiles to fix typo in paragraph seven.)
Edward Chancellor is the author of “The Price of Time: The Real Story of Interest”.
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