Something big may be about to break into the markets as rates continue to rise

On September 21, 2022, US Federal Reserve Board Chairman Jerome Powell stops by during a press conference in Washington, DC.

Saul Loeb | AFP | Getty Images

I wrote about the action of central bankers last week, suggesting that the rapid rise in interest rates, led by the US Federal Reserve, would soon lead to a significant disruption of financial markets, both at home and abroad.

Well, it looks like that day has come.

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On Wednesday, the Bank of England, the historic model on which the modern central bank is based, intervened in the UK bond market, reportedly, to prevent rising “Gilt” yields from sinking some British pension funds. (Gilts are British bonds so named because of their gold-edged paper on which they were once printed.)

Unbeknownst to many of us, some British pension funds, which in total hold around $ 1.7 trillion in assets, have used derivatives both to hedge a rise in interest rates, but also to amplify the earnings from from some types of operations.

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

As rates hiked, some of these deals plummeted in value, creating margin calls on those same funds, triggering an almost Lehman moment in the UK financial markets.

The BoE stepped in and bought bonds, dropping long-term yields by more than a full percentage point and pushing US 10-year yields here as well. This led to a reflected rally in equities in bonds in Europe and the US on Wednesday, which was nearly canceled just 24 hours later.

“An even bigger break” in sight

We are on the verge of an even bigger break in the global financial architecture as Federal Reserve officials are now doubling down on the need to raise rates to combat what appears to be a decline in inflation, regardless of the consequences.

Some Fed officials have admitted that rates will continue to rise even during a recession and that rate hikes will not stop until inflation drops to the Fed’s stated target of 2%. It is unclear whether this means raising rates above the current perceived target of 4.6% or keeping rates high for an extended period.

What is clear is something I have been suggesting for some time: that recession is a feature, not a bug, of Fed policy, echoing the policy decisions of the late Paul Volcker who, in the early 1980s , raised interest rates to 20% to induce an inflation-killing recession and a tame inflation that had raged for over a decade.

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I have argued that the historical analogue chosen is the wrong one to use as a guide to current policy.

For the record, while Volcker’s draconian policies managed to tame inflation, they also came with an associated and unexpected cost even beyond the deep double-dip recession that followed.

The rapid rate hike in the United States put a strain on Latin American nations that had borrowed substantial sums of money from U.S. commercial banks in the 1970s.

Those debts, largely denominated in dollars, have been hammered by a combination of higher rates and falling national currency values, effectively and substantially increasing the debt service burden on those nations.

With the sharp rise in rates, Latin American nations threatened to default on their outstanding debts, an event that could have made many American money center banks de facto insolvent. Volcker had no choice but to stop raising rates and start cutting them to ease tensions in the US banking system.

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

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

The Fed will have to quit soon

We seem to be reaching, or may have already crossed, that threshold again.

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

If I am right, the forced purchase of British bonds by the Bank of England signals to the first central bank a more restrictive monetary policy, but it will not be the last. It’s only a matter of time before the next shoe falls off.

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

They might deny it. They may not want to. They may refuse to even acknowledge the possibility of such a drastic change in politics.

But they will change.

I am reminded of a comment former Fed Chairman Alan Greenspan made to me in a private conversation during the long-term capital crash while under pressure to bankrupt the company.

He said that in theory he would agree that letting the markets handle failure is a good idea, but “in practice, it is not a social experiment that I am willing to undertake.”

His words will ring true again in the days and weeks to come.

Ron Insana is a CNBC associate and senior Schroders consultant.


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