The writer is an FT contributing editor and global chief economist at Kroll
As the era of cheap money comes to an end amid a global central bank tightening cycle, UK pension funds have been among the first bodies to float to the surface. I am certain they will not be the last. Margin calls sparked by the funds’ liability-driven investing (LDI) forced the Bank of England back into quantitative easing. And on Tuesday the BoE widened its bond-buying programme, warning of a “material risk to UK financial stability”.
The troubles brought on by Chancellor Kwasi Kwarteng’s “mini” Budget are a harbinger of unfortunate events to come across developed markets in the next year. Governments will spend more; investors will be the dominant disciplining force; and central banks will break other things in trying to break the back of inflation.
Even as monetary authorities withdraw liquidity, war and the energy crisis will require developed markets to spend much more in the coming year. At the end of September, Germany, the pillar of fiscal rectitude, announced a €200bn investment package to cap gas prices for industry and consumers into 2024. While finance minister Christian Lindner insisted the extra euros will not be inflationary, German CPI soared to a 70-year high last month and bund yields have followed. Credit default swaps rose to the highest since April 2020 even as Lindner insisted Germany is “expressly not following Britain’s path” by committing to a new level of borrowing.
An even bigger potential trigger point is Italy, which is particularly exposed to Russian gas, has little fiscal room and is already under pressure in bond markets despite support from ECB bond reinvestments. The yield on the benchmark 10-year note jumped the most since before the pandemic last week, following a fiscal warning from Moody’s Investors Service to the country’s likely new centre-right government.
Price moves in the next year will be as swift and dramatic as they have been in the UK partly because markets are already highly stressed. The global central bank hiking cycle has tightened financial conditions and sapped liquidity. This is not a bug. It is the point of hiking rates. But as central banks continue hiking, something will probably break.
With the Federal Reserve tightening more aggressively than other major central banks, the US dollar index (DXY index) has risen 17.4 per cent since the beginning of the year. This exports inflation from the US, forcing other countries to tighten more. And as the Fed considers a fourth consecutive 75-basis point hike, the US Treasury’s Office of Financial Research’s Financial Stress Index is near a two-year high, credit spreads have widened, corporate defaults more than doubled over the course of the summer and Bank of America announced its gauge measuring stress in credit markets was at a “borderline critical level”.
What, then, is likely to break? Post-financial crisis, big US banks are much better capitalised. That is not always true in Europe. And on neither continent can regulators be confident about what lurks in the shadow banking sector. Even very liquid assets — such as gilts in the UK — may be a source of trouble. Investment grade corporate debt is an issue for the US. Overall, non-financial corporate debt has reached almost 80 per cent of US gross domestic product. Roughly one-third of this is rated BBB, the bottom rung for investment grade. Downgrades will force debt sales from a number of portfolios, sending prices down and potentially leading to UK-like margin calls.
Another body to float to the surface in this tightening cycle may be alternative assets, including private equity and debt. Alternative assets have grown rapidly, almost doubling as a percentage of total financial assets since 2006. Their losses this year have been far less than those in public markets. While this may be a case of better investment strategies, it may also portend bigger losses to come.
The UK’s experience reminds us that central banks have a very fine line to walk between fighting inflation and supporting financial stability. After years of bailouts, investors seem to be ignoring “this time we mean it” warnings and betting on a pivot. At the same time, governments forced to spend will be working at cross-purposes to the inflation fight. Opec+ has decided to pile on by cutting supply and raising energy prices again. Given oil is largely priced in dollars, the dollar remains the US currency, but the world’s problem. Market dislocations alone will not be enough for central banks to U-turn and cut rates. A financial crisis that kicks off a recession would, but that would be the worst possible way to lick inflation.
