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Tuesday, October 4, 2022

Crisis, Pre-Crisis, Or No Crisis?

I divide the regimes for the global capital markets into three states: crisis, pre-crisis, and no crisis. The one term that is non-standard is pre-crisis; it is a state where something has gone horribly wrong in funding markets, but it is not yet well known and there is a hypothetical possibility of a full financial crisis being averted.

My “no crisis'“ state does not imply that we cannot find panicking people in the financial press. Unimportant markets like Magic the Gathering™️ cards, crypto, or equities might be blowing up, but as long as the funding markets are not touched, the effects on the real economy will be limited. Those markets are largely zero sum transfers of wealth between participants, and not used to raise funding for investment (fixed and inventory). Since we can always find an unimportant market blowing up somewhere, if we labelled them “financial crises,” we would be living in a permanent “crisis,” making the term meaningless.

For an example of a pre-crisis state, I would point to the situation in 2007 or even 2006: things were going wrong, but could possibly have been contained. By Lehman weekend in 2008, the Financial Crisis had definitely started, but it is arguable that a disaster was inevitable earlier in the year — it was just that conventional economists and most equity investors were oblivious to the problems.

I do not offer forecasts or investment advice, but based on what I have seen publicly discussed, I see nothing that says that we are in any worse state than pre-crisis — unless you are involved in GBP rates markets. I have seen various sensationalist attempts to suggest that various banks are insolvent based on 5 year credit default swaps (CDS). but this was just an attempt to recapture the excitement of 2009 on perma-bear websites.

U.K. — Local Crisis, Certainly

We can say U.K. rates market entered a financial crisis by definition — the Bank of England was forced to intervene to restore orderly markets. There are still grumblings about liquidity pressures for pension funds, but at the time of writing, gilt yields are near where they were pre-mini budget. Also based on reports at the time of writing, the cumulative Bank of England intervention was smaller than the maximum one day purchases for the intervention (5 billion pounds). This is as expected — the BoE just needed to send a price signal to the market as to what it considered “disorderly,” and then it is time for gilt shorts to cover or be squeezed in turn.

The question is: is this local crisis the beginning of a global crisis, or would it be contained? Once again, my view is that the evidence suggests we are at worst at “pre-crisis.”

The amount of direct contagion from GBP rates markets to elsewhere is going to be almost non-existent. Although some entities might have had speculative long gilt positions, such positions would consume a lot of the available risk budget. I doubt that you could fill a minivan with foreigners who were bullish on GBP rates ahead of the mini-budget. Nobody would use GBP rates to match foreign currency liabilities, other than as a short-term proxy hedge. In Canada, firms can use currency-hedged U.S. Treasuries as proxies for Canadian rates, but that is at best a short-term expedient to give time to enter into positions into the much less liquid CAD rates market. The high correlation of USD and CAD rates helps reduce the risk profile of this proxy hedge. The GBP market is less liquid than EUR/USD markets, and correlations to other markets are also weak.

One could argue that this was a “canary in a coal mine”: other markets feature similar strategies, and are on their way to catastrophe. The problem with that argument is that this was a liquidity event, not a losses event — these were hedges against liabilities, so the pension balance sheets were fine. Instead, they were stuck by margin calls. In order for these events to repeat elsewhere, you would need a large mass of investors all on the same side of the trade. Furthermore, the entities would also have had to similarly neglected liquidity considerations under adverse rates movements.

Pointing to “large” swap notionals entered into by pension funds elsewhere tells us little. Swaps are zero sum, and for every dollar notional receiving there is a dollar paying. Of course pension funds will be the largest receiving group — who else is going to be receiving fixed in swaps? (If you receive fixed, you are in a position that is economically equivalent to a leveraged long position in a bond.)

Instead, what matters is the size of positions relative to the remaining risk-taking capacity of other players. Pension funds who have the trading infrastructure to receive fixed in swaps but have positions much smaller than their risk limits are in perfect position to lean into any attempt to push swap rates “too high.”

Maybe that is happening else, or maybe it is not. You pays your money and you takes your chances.

Why Pre-Crisis?

Despite pathetic attempts to point to charts saying that “<something> is the worst it has been since Lehman!,” I have not run into any financial variables that look like anything other than normal volatility. Sure, risks have risen, and so have risk premia. That is what they are supposed to do in this environment.

In order to get a real crisis, we need funding markets to seize up. As anyone short gilts last week discovered, a liquidity event can caused forced deleveraging — but a liquidity event without a corresponding solvency issue (i.e., no negative equity) is exactly what central banks are good at stopping. They intervene to restore orderly markets, and the affected parties can use that cover to rearrange their balance sheets.

To get a solvency event, you need negative equity. For an interest rate shock, we would need entities that were massively long duration versus liabilities. Although folklore suggests that everyone is doing that, in practice developed government bonds are the most hated asset class on the planet. Managers want to take credit risk, not long duration risk.

To reliably disrupt funding markets, you need credit losses. Maybe I am missing something, I am not seeing large pockets of losses that is going to eat into systemically important financial institutions. Housing markets might be teetering due to higher mortgage rates — but the defaults are still potential, not realised. Meanwhile, those mortgages are typically securitised and on the balance sheets of investors who can absorb credit losses.

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(c) Brian Romanchuk 2022

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