Something big could break in the market

Jerome Powell, chairman of the board of the U.S. Federal Reserve, pauses at a news conference in Washington, DC, on Sept. 21, 2022.

Saul Loeb | AFP | Getty Images

Writing about central bankers’ actions last week, I suggested that the rapid rise in interest rates, led by the US Federal Reserve, would soon lead to a meaningful rupture in financial markets, both at home and abroad.

Well, it seems that day has arrived.

On Wednesday, the Bank of England, the historic model on whose practices modern central banking is based, reportedly intervened in the UK bond market to prevent rising ‘gilded’ yields from hurting certain UK pension funds. (Gilts are British bonds named after the gilt-edged paper they were once printed on.)

Unbeknownst to many of us, some UK pension funds, which total about $1.7 trillion in assets, used derivatives to both hedge a rise in interest rates and boost profits from certain types of transactions.

In other words, pension funds used borrowed money to speculate in financial markets.

As interest rates skyrocketed, some of those trades fell in value, triggering margin calls on those same funds, triggering an almost Lehman moment in UK financial markets.

The BoE stepped in and bought bonds, pushing long-term interest rates down by more than a full percentage point, as well as lowering US 10-year yields. That led to a knee-jerk market rally in Europe and the US on Wednesday, which was wiped out just 24 hours later.

‘An even bigger breakthrough’ ahead

We are on the cusp of an even greater rupture in the global financial architecture as Federal Reserve officials now double the need to raise interest rates to combat seemingly falling inflation, regardless of the fallout.

Some Fed officials admitted that interest rates will continue to rise even during a recession, and that rate hikes will not stop until inflation falls to its stated target of 2%. Whether that means raising rates above the current target of 4.6% or maintaining rates for a longer period remains unclear.

What’s clear is something I’ve been suggesting for quite some time – that recession is a feature of Fed policy, not a bug, following the policy decisions of the late Paul Volcker, who in the early 1980s pushed interest rates to 20 percent. % increased in an inflation-killing recession and tame inflation that had been raging for more than a decade.

Fed needs to catch up with inflation without surprising markets, says Stanford's John Taylor

I have argued that the historical analog chosen is the wrong one to use as a guideline for current policy.

Before the historic record, while Volcker’s draconian policies succeeded in curbing inflation, it also came with additional and unexpected costs, even beyond the deep double-dip recession that followed.

Rapidly rising interest rates in the US put pressure on Latin American countries, which in the 1970s had borrowed significant amounts of money from US commercial banks.

That debt, largely denominated in dollars, was plagued by a combination of higher rates and declining domestic currency values, effectively and significantly increasing the debt burden for those countries.

When interest rates rose sharply, Latin American countries threatened to default on their outstanding debts, an event that could have effectively left many US money center banks insolvent. Volcker had no choice but to stop raising rates and start lowering them to ease the pressure on the US banking system.

So even under those circumstances, the Fed raised interest rates until something broke.

They would do that again in 1987 (October stock market crash), in 1994 (Mexican peso crisis and Orange County bankruptcy) and would try in 1997 and 1998, but were held back by the Asian currency crisis and the Russian default and subsequent, and massive failure of long-term capital management. LTCM was a hedge fund that used so much borrowed money from US banks to speculate on international bonds that its collapse threatened the solvency of the entire US financial system.

Fed will have to stop soon

It seems that we are once again reaching that threshold – or perhaps have already crossed it -.

The near collapse of the UK bond market may well be the canary in the coal mine, indicating that there are unknown or unrecognized pockets of leveraged speculative betting in both near and far corners of the world.

If I’m correct, the Bank of England’s forced purchase of British bonds is a sign that the first central bank is blinking for tighter monetary policy, but it won’t be the last. Now it’s only a matter of time before the next shoe drops.

If history is any guide, and it almost always is in financial markets, the Fed will be forced to pause, if not reverse, policy in the relatively near future.

They can deny it. They may not want to do it. They may even refuse to recognize the possibility of such a drastic policy change.

But they will change.

I’m reminded of a comment former Fed Chairman Alan Greenspan made to me in a private conversation during the long-term capital collapse as he was pressured to make the company fail.

He said in theory he would agree it’s a good idea to let markets handle the failure, but “in practice, it’s not a social experiment I’m willing to undertake.”

His words will sound true again in the coming days and weeks.

Ron Insana is a CNBC Contributor and Senior Advisor at Schroders.

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