Four trouble spots that could threaten financial stability

Dallas is nearly 5,000 miles from London. But when UK gilt markets imploded last week – forcing the Bank of England to issue £65bn intervention

Fisher has warned for years that a decade of ultra-loose monetary policy would create pockets of future financial instability. As such, he sees the UK gilts drama (which came about because pension funds mishandled highly leveraged bets) as not an isolated event – but as a sign of a trend.

“This [foolish strategy] always happens when interest rates are near zero and things have gotten extreme,” he told CNBC, noting that the crisis is “indicative of other things that are likely to emerge” as investors and institutions became dangerously over-leveraged and “I think interest rates will stay low forever”.

Quite like that. Markets are already getting jittery and volatile, not just in the UK. A market stress index compiled by the Washington Office for Financial Reporting has now jumped to one two-year high.

And while Fisher didn’t identify where “other things are likely to show up,” I suggest there are at least four places that investors (and regulators) should be watching closely right now (other than other pension funds).

One is the state of mutual funds, or vehicles that allow investors to redeem assets at will. As the IMF notes in its forthcoming communication Financial Stability Reviewthis sector has grown to $41 trillion in assets.

Many funds are managed conservatively. But some have switched to illiquid assets to seek returns – and the IMF is now warning that this liquidity mismatch is “contributing to volatility in asset markets and potentially threatening financial stability” if investors panic.

Some observers might reply “well, duh”. Finally, liquidity and duration mismatches are usually the source of financial drama, and this is nothing new. But it needs to be watched, especially as nobody seems to know how big the potentially illiquid exposures are.

A second topic is government bonds. Last week’s gilt crisis is partly due to the peculiar nature of the UK pension fund system. But not quite: all Western government bond markets struggle with the fact that liquidity increasingly evaporates in moments of stress. One reason is that big banks no longer act as market makers due to stricter regulatory controls.

This liquidity problem led to a near-disaster for Treasuries in March 2020, and some observers fear a so-called “volatility vortex” could re-emerge in US markets. And while central banks are trying to fix this, it’s not easy.

After all, as Paul Tucker, former BoE deputy governor, noted this summer, arguably the only truly effective “solution” would be for central banks to promise to always offer liquidity for supposedly “safe” assets like government bonds. in a crisis. The BoE did this last week as an emergency measure. But no central bank wants to make a lasting promise, as it is designed to reduce, not increase, market interference.

A third issue is housing. As the Bank for International Settlements noted in a recent poignant report, the global housing market has been looking odd by historical standards lately. Correlations between different regions have skyrocketed and house prices have recovered surprisingly quickly after the pandemic recession.

Even more notably, prices continued to rise earlier this year, even after monetary tightening began. While this may reflect structural changes such as working from home, it was also a consequence of past ultra-loose monetary policy.

In recent weeks, however, there has been a staggering rise in the 30-year US mortgage rate in America to 6.75 percent, the highest rate since 2006. That will almost certainly cause house prices to fall in the coming weeks. Brace yourself for volatility – and stress – in mortgage bonds.

A fourth problem is private capital. Arguably the biggest difference between the current tightening cycle and previous ones (apart from the striking extent of previous monetary easing) is that much of the free rush has taken place in private equity and venture capital funds, not (only) in the public markets.

This makes it harder than before to track pain when the money cycle turns. We can see that junk bond prices have fallen recently; We cannot track the true value of assets held by private funds. Maybe they mark them correctly. But I doubt it, especially as they’re increasingly selling assets to each other. Expect future billing.

This list of potential trouble spots is not exhaustive (emerging market investments are another story). Also, they may not “show up” right away given how much money is still swirling around due to past lockdowns. A revealing detail of the OFR’s market stress index is that it has risen mainly due to higher market volatility – not worsening financing conditions. The latter still look quite stable in the index.

But “still” is the key word here: if central banks continue to hike rates, funding will inevitably shift as well. Investors should brace for more surprises outside of the UK. Unless, of course, next week’s IMF meeting in Washington reveals that central banks are on the verge of (yet another) turnaround.

gillian.tett@ft.com