Risks seen and unseen
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In the USA and UK, it looks increasingly likely that QE and the drive to report higher corporate earnings per share (using cash to buy back equities rather than fund productive capital investment) has driven a sharp slowdown in underlying productivity and value added growth. These developments are now also limiting both demand and supply side potential growth.
For most financial market participants, the focus on Fed tightening generally centres around an actual increase in the Fed Funds rate or some other interest rate – but practically, it may be a long time before the Fed can actually regain control of the Fed Funds rate and we may expect that central bankers generally fear raising interest rates and will probably seek to avoid doing so until their economies have sufficient momentum to withstand any adverse bond and/or equity market reactions – and this suggests that they will defer raising rates for as long as possible.
But in this game of bluff, double bluff and expectations management, we can note that the last financial market ‘crisis’ to be caused by an actual rate hike was probably 1994’s bond market and Mexico crisis. The Asian Crisis did not involve an actual rate hike by the Fed and the LTCM event in 1998 certainly did not. The Fed was raising rates around the time of the NASDAQ debacle but the actual peak in the markets actually occurred when the regulators closed down Freddie and Fannie’s then massive activities in, and support for, the corporate bond markets. Conversely, the Fed raised rates between 2004 and 2006 but the global credit boom only failed in 2007-8 when the frailties of CDOs based on matrix mathematics were revealed. Similarly, the sell-off that occurred in markets after QE1 ended did not involve higher rates, and neither did that at the conclusion of QE2.
It may therefore well be that the current credit boom that is driving both the corporate bond markets and by extension the equity markets, and global capital flows, whilst vulnerable to an increase in official rates, may be undone by quite a different event or variable.
One issue is the Fed’s Reverse Repos which were intended to be contractionary for credit, but have been expansionary because the benefit in terms of the implied added collateral within the system caused by the Fed releasing Treasury bonds into the financial system through its reverse repos outweighed the notionally contractionary influence of the commercial banks losing a few of their anyway abundant excess reserves. What this means is that when the Fed stopped doing these reverse repos and in fact reversed many of them in late May and the first two weeks of June, the impact on the system was contractionary (rather than expansionary as the textbooks would have predicted) given the shortage of collateral that this created, and indeed there was a surge in repo market failures as participants found it increasingly difficult to ‘deliver’ collateral. By way of background, after onset of the global financial crisis, the repo markets evolved to become the key short term credit market. But when the Fed removed Treasuries from the system in early June, it created collateral shortage that will have cost those involved 3% penalty rates. Interestingly, the Fed seems to have responded to the problem by conducting more Reverse Repos and by expanding its own asset purchases, with the result that money and credit data have looked much better.
We can draw two conclusions. First, central banking is increasingly tricky with policies causing unintended consequences and the chances of a mistake or unintended consequence is increasing. Secondly, if such a mistake were large enough, then the global financial system could suffer and whilst such a risk does not seem imminent, the risks are rising and we can expect to see volatility beginning to rise. Identifying just what might upset markets is hard, and may well begin with something quite small in itself – such as the Fed’s reverse repo transactions, and back in 2007, the rise and fall of matrix mathematics in product construction and before that the over-reliance on VaR to measure ‘risk’.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
