There was plenty of “Lehman moment” chatter early this week, when an overblown social media frenzy centered on Credit Suisse prompted mainstream outlets to devote blanket coverage to the bank’s fraught overhaul.
The bigger story, though, remains the UK’s “near miss,” and the Bank of England’s rescue mission to prevent a collapse in the nation’s pension complex.
I’ve warned the UK isn’t out of the woods. BofA underscored the point in a new note called “Risking a Bear Stearns moment” which, in addition to flagging the possibility for contagion, doubles as a reminder of how we got here, so to speak.
Analysts led by the bank’s Benjamin Bowler set out what they called “Lessons from the UK crisis on volatility and global risks.” They enumerated those lessons via five bullet points. This is a case where paraphrasing the original would be to do it a disservice, especially considering my penchant for taking something that was deliberately concise and turning it into something that’s needlessly verbose. Below are Bowler’s (slightly abridged) lessons:
- Painful withdrawal: A highly-levered system “addicted to doves” is being rudely awakened by the fastest, most aggressive monetary policy tightening in over 40 years, and wide cracks are emerging.
- Hidden risks: Even when the main risk facing markets is visible and relatively slow-moving (as CB tightening has been this year), markets are full of hidden risks and non-linearities that only reveal themselves in times of stress. This episode should remind equity investors of the existence of “unknown unknown” secondary effects (at times coming from abroad) and force them to price in a thicker left tail in stocks.
- Testing the Central Bank put: The trade-off between fighting inflation and maintaining financial stability is a complication for central banks not faced in 35 years since the central bank put was invented. The BoE had to pause their inflation fight last week to restore financial stability, and the Fed could be close to having to do the same.
- Relief only temporary: The BoE’s intervention prevented a real catastrophe for UK assets. But the emergency policy response didn’t fix the underlying problem, namely the highest rates of inflation in decades. In fact, the BoE’s actions in the Gilt market are counter to their stated inflation-fighting plan, and each test of the central bank put may see less and less of a calming impact on markets. If the BoE put were to fail (or the next test of a central bank put), the risk is that it’s akin to the Bears Stearns moment of the 2008 crisis, causing investors to further question central banks’ ability to provide protection in the era of high inflation. The Fed facing a similar dilemma and failing would be the Lehman moment.
- Dented Central Bank credibility: In fact, even the relief rally after the BoE intervention was underwhelming compared to other central bank rescues post-GFC. The S&P 500 hit new YTD lows several times in that same week, as did the local FTSE 100. To us, this is a sign that central bank credibility is already dented, and strengthens our view that the biggest risk to markets is a test and fail of the Fed put.
Those five talking points from Bowler are very compelling, not to mention quite poignant.
The problem in 2022 is that inflation constrains central banks in their capacity to backstop markets, given that functioning as a dealer of last resort would invariably be seen by many as a pivot to easing — a “bend the knee” moment that risks exacerbating inflation.
Such criticism wouldn’t be strictly accurate, but it wouldn’t be wholly unfounded either. And, depending on the circumstances, deploying the balance sheet could absolutely be inflationary even when central banks are acting in a targeted manner to address market functioning and/or provide liquidity where it’s gone completely MIA.
Bowler went on to write that although “it may seem like the UK experience of the past week is an idiosyncratic phenomenon that may remain isolated to the UK, we are concerned about the read through to broader market psychology with respect to the belief in the ability of central banks to provide relief when it is most needed while they are already severely constrained by persistently high inflation.”
His note is perhaps even more timely than he imagined when he started writing it a day or three ago. On Monday and Tuesday, markets began to anticipate a dovish pivot from central banks, and rallied as a result. If inflation doesn’t abate (or if the rally itself eases financial conditions, thereby fanning the flames) that pivot might not be feasible. At that point, the credibility question would become topical indeed assuming another “event” came calling.
“Timing this risk is hard and oversold markets could create another June-like bear-rally,” BofA remarked, before noting that “between Bear and Lehman, the S&P rallied 10% before selling off.”
[blockquote] The problem in 2022 is that inflation constrains central banks in their capacity to backstop markets, given that functioning as a dealer of last resort would invariably be seen by many as a pivot to easing — a “bend the knee” moment that risks exacerbating inflation.[/blockquote]
Can you explain the psychology/power dynamics/politics behind some of this?
I mean, inflation was precipitated by a situation in which people were paid to stay home — so demand stayed high while production tanked. The equity rally started with all the backstopping of corporate paper by the Fed, and then hit the top of the roller coaster with the cash gusher of PPP and various bailout programs.
So, why are central bankers unwilling to comment on this sort of dynamic when they’re taken to task for not managing the vagaries of the currency more deftly? i.e., “the best way to fight this inflation might be with fiscal levers, like higher taxes or less spending, than with monetary levers like higher rates.”
I guess i just don’t understand why fiscal authority is “political” but monetary authority is “bureaucratic” or administrative in nature (Erdogan aside, i guess).
What would be the problem with a Fed that said “listen, we’re probably going to have systemic inflation until the excess cash spent into the economy by the fiscal authority gets sucked out again through higher taxes or lower spending.” After all, even higher rates just sort of keeps the cash “out there” in the sense that the buffer is with the Fed (in the form of higher rates) instead of with the fiscal authority (in the form of freedom to spend more than it takes in from taxes).
In a way it’s sort of like there’s been a power shift — with the Fed now having much higher rates as neutral due to having to soak up all this excess cash/demand, and the fiscal authority being diminished as a result (or at least until a politico comes along with ‘belt tightening’ rhetoric sufficient to slow the economy to the point where the Fed begins lowering rates to compensate).
I guess i’m wondering why there isn’t, or can’t be, more explicit dialogue and cooperation. Is this a governance problem? A political problem? A human nature problem? I don’t really know what to think.
That.
Even in their desire to fight the impact of energy and food inflation, governments could at least try to be more disciplined rather than simply providing subsidies (with their inflationary impact).
Use quotas/rations. I guess energy sources and consumption follow more complex patterns than during WWII. OTOH, state capabilities have increased too.
It’s just willful blindness and/or political cowardice.
Unless by “pivot” we mean any outcome that isn’t a 75bs hike in Nov. followed by 50 in Dec. and continued balance sheet runoff to the tune of $95b/month, I don’t understand the binary nature of this debate. The FOMC could go 50 + 25 and pause while continuing with runoff at current levels; 50 and pause with a continuation of runoff and additional hikes in 2023 dependent on the data; 50/75 and signal it’ll be slowing QT in 1Q23; etc. The point is that it remain committed to reining in too-high levels of inflation; how it gets there is a secondary concern. The concern about systemic risk is problematic, given the opaque nature of levered, speculative finance. But we’re in a different place than we were in 2008-09 (see stress tests), and the orderly unwind of a single chronically mismanaged SIFI or a couple of over-levered hedge funds should not ring the bell on CBs efforts to drain excess liquidity from the system. Finally, is it really the Fed’s job to backstop the policy errors of other CBs (BoE, BoJ) or policymakers in other countries (Tories)? And if that’s where we are, is it fair to ask who the beneficiaries of that expanded mandate are?
I like the scenario you posit. Combine rate hikes and runoff in a way which keeps the pressure on without gutting the economy.
+1
I agree, it’s highly unlikely to be binary.