ENDING THE EASY MONEY ERA
The financial crises of recent years all show an end of the easy money era will have chilly economic tailwinds. It isn't a repeat of the 2008 financial crisis, this is a brand new one
WHAT does the Liability Driven Investment (LDI) crisis under Liz Truss premiership have in common with the collapse of Crypto giant FTX? It’s the same thread linking it to the demise of Silvergate and Silicon Valley Bank. Welcome to the end of the easy money era as interest rates are hiked up and quantitative easing is put in reverse.
Ending easy money
While all the aforementioned crises can be explained by individual circumstances, nevertheless they all have one thing in common. They were all caught out by the rapid raising of interest rates by central banks across the world.
Putting things simply, what we are seeing right now is the onset of a new longer term economic environment. When central banks from the Federal Reserve in the USA to the Bank of England in dear old blighty faced the inflationary crises post-pandemic, interest rates were sent sky high to solve it. But the thing about rising interest rates dramatically high and fast is that it inevitably sends bond prices crashing down.
The bond market remember has an inverse relationship to interest rates. When the cost of borrowing money rises (interest rates rise), bond prices usually fall, and vice-versa. The reason for this is easy to grasp, most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond.
But we aren’t talking about an economic environment of falling interest rates, we’re dealing with the reverse situation. Instead if interest rates rise - as is now the case on steroids - investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.
At the same time the era of quantitative easing (which had kept Europe breathing after the consequences of the 2008 Financial Crisis) has ended. These central banks have begun winding down QE and in some cases pushing things hard into reverse gear. The end result? A lot of financial ripples are going to be felt and quite a few players in the economy are going to be caught on the hop.
Linking the crises
Under Liz Truss brief premiership UK pension funds found themselves scrambling when left holding LDIs which had assumed bond yields would never rise. The panic forced the Bank of England to step in to rescue pension funds and along the way brought down Truss government as collateral damage.
It’s easy - and true incidentally - to blame Truss and Kwarteng for the chaotic LDI pensions crisis that briefly unfolded. Yes, their decision to unveil an uncosted mini-budget sparked things, but the reality is the LDIs market the pension funds were playing in were under stress long before Truss simply tipped things over the edge.
The bet the UK pension funds were engaging in with their LDIs is ‘borrowing short’ and ‘lending long’. Borrowing short means the interest you pay on your borrowing changes rapidly. For example, if interest rates rise fast you pay much more per month. ‘Lending long’ means buying with the borrowed money, assets that yield a fixed and initially higher rate than your interest costs (in this case the assets were government bonds).
Here we see the linking thread which triggered the UK LDI crisis under Liz Truss: rising interest rates. Likewise in the case of the Silicon Valley Bank (SVB) collapse we find the same story of rising interest rates causing massive economic damage to those caught out.
If we examine SVB’s problems they all started with the investment boom that followed the start of the coronavirus pandemic. SVB is the go-to institution for most California venture capitalists and start-ups. Thus it found itself literally flush with cash as billions of deposits from young companies holding investor cash ran to SVB. As the Financial Times described it,
“There was so much money — almost $130bn in new deposits in 2020 and 2021 — that SVB could not lend it all out. Instead, they invested much of the money in long-term US government-backed bonds. The bonds have no credit risk, and because SVB’s deposits cost almost nothing, they were profitable, too, despite paying only a few percentage points of interest”
Pay extra attention to that last point, ‘despite paying only a few percentage points of interest’. That’s the key reason why SVB has disinterested this week. Their whole approach could only work while rates remained low.
They didn’t.
In the USA under the Biden administration the new economic challenge became slaying the dragon of inflation. As a result the Federal Reserve battled the dragon by raising interest rates. Thus suddenly deposits became more expensive. In just the past year, SVB’s deposit costs rose from 0.14 per cent to 2.33 per cent. In just one year. At the same time their yields on long government bonds didn’t budge.
Result? A profit squeeze beckoned and SVB discovered investors and depositors weren’t going to wait around for the bank to take measures to resolve the problem it faced. SVB - as with the UK LDI crisis exposed the consequences ahead as the easy money era was being brought to an end. Rising interest rates, turning off the QE taps all resulting in a collapse in bond prices, catching our actors in the economy on the hop.
Things are no different with the epic downfall of crypto giant FTX earlier in the year. It too exposes the truth of my argument here. This draining of liquidity, and a return of genuine yields on real assets such as Treasury bills has served to crash the price of the flimsier alternatives such as Bitcoin. Suddenly people want the real deal. Bitcoin is to be found in the ‘toy town’ section of the financial industry. Bitcoin suddenly becoming less attractive by comparison to Treasury Bill yields triggered the crisis at FTX. Sure, I accept that circumstances vary in each three of the cases I’ve outlined but a common thread runs through all of them: tightening of monetary policy was the root cause of each crisis. And, dear readers, a tightening monetary policy is here to stay for the foreseeable.
The music has ended
Over the course of last year the music facing the global economy and financial markets has been slowing down. Not stopping, just slowing. As central banks slowly inched interest rates up, they expected everyone to be listening and paying attention. But quite a few were deaf to the changing realities and now the music has stopped and a lot of actors in the economy are scrambling desperately to find a seat. Many will fail, and the economic pain will be felt widely and for a long time to come.
What worries me the most is that I simply do not think very many of our political class in the UK or even Scotland in particular, really understand things. Truss mini-budget ridiculousness exposes a fundamental economic illiteracy lurking in our governing political class. We should all be concerned about that.
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