This has already been the most torrid year for investors since the 2008 financial crisis. Just about all major stock market indices are down about one-fifth since the beginning of 2021, with the S&P 500 down 24% and the Nasdaq down 32%. Wall Street has posted its longest streak of quarterly losses since 2008. The JSE Top 40 Index is down a comparatively moderate 14%.
What has made this year especially tough for investors is that the usual haven of safety in tough and volatile times – the bond market – has been equally, if not more, treacherous.
As inflation has soared and central banks have pledged to take immediate and drastic action, bond yields have exploded, sending prices tumbling. The yield on the US 10-year Treasury bond has more than doubled, from 1.51% to 3.79%.
Instead of merely closing the all-you-can-eat buffet that was 2020, Jay Powell at the Federal Reserve has decided to blow up the whole restaurant. If monetary policy in 2020 and 2021 was far too easy, now it is suicidally tight.
This risks being the biggest monetary miscalculation in history.
What makes the above all the more concerning is that the bond markets are in effect broken. As the Fed has aggressively hiked rates and also shrunk its balance sheet by selling bonds worth $95-billion a month in the form of “quantitative tightening” (QT), analysts at Bloomberg estimate that between QT and higher interest rates, liquidity worth a total of $200-billion is being drawn out of the financial system every month.
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The first-level effects are clear: the valuations of portfolios, outside of cash or aggressive short positions, have been decimated. This is the worst year in history for the classic 60/40 portfolio spread between bonds and equities. However, to paraphrase Donald Rumsfeld, while the known knowns and increasingly the known unknowns of this monetary mayhem are becoming apparent, we can only surmise what the unknown unknowns will be.
It is useful to start with the US property market. As the standard 30-year US mortgage rate has skyrocketed, doubling this year from 3.27% to 7.06%, the market is starting to crash, posting its largest monthly declines since 2009. Many analysts believe that a nationwide 25% to 35% drop in house prices is realistic, if not somewhat optimistic.
Such a drop would have an immediate effect on inflation data, as much of what continues to hold up core inflation are housing-related expenses. It could well be that in 12 to 18 months’ time, in the teeth of a crushing recession, the Federal Reserve will have to worry more about deflation than inflation.
If current concerns are regarding liquidity, risks around solvency could be next. The rumours swirling around Swiss lender Credit Suisse could be a harbinger of a broader financial crisis to come. Its credit default swaps – the price of insuring against its bankruptcy – have risen 361% year to date.
There are even more concerning systemic risks embedded in the nontraditional financial sector, such as nonbank providers of mortgages and private equity firms. Private equity has become a major source of unregulated loans to overindebted corporates. As rates soar, the balance sheets of these aggressive lenders will become increasingly distressed.
This is leaving those businesses and financial institutions which depend on constant sources of financing extremely vulnerable, not to mention the risks to exposed sovereigns. The UK is the most recent and prominent example of this.
While markets have fallen, a prolonged financial crisis and devastating global recession with heightened geopolitical risks could mean that markets have another 30% to drop.
You have been warned. BM/DM