Mr. Market’s Hissy Fit May Be Over….For Now

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After two days of wild rides in global equity and some other key markets, Asian and Europe bourses are stabilizing. The Dow fell 832 points on Wednesday, or 3.2% and another 546 points, or 2.1% yesterday. The S&P 500 fell 3.3% Wednesday and 2.1% on Thursday. Oil stocks took it on the chin. With all that drama, US stock averages have fallen to their level over the summer.

The proximate cause was Fed Chairman Jerome Powell’s enthusiasm over the state of the economy, which translates into more interest rate increases, and sooner rather than later. But there is also a lot of nervousness in Europe over the wobbly state of Italian banks and the staredown between the Italian government and Brussels about Italy’s plans to run a somewhat meaty deficit next year. It should be obvious that Italy, which has tons of slack in its economy thanks to GDP having fallen nearly 6% since 2008, needs stimulus, not austerity, but the ideologues in power in Europe won’t hear otherwise.

Frankly, it has been remarkable to see markets stay at such elevated levels for so long as central banks around the world are exiting QE and trying to back out of super low interest rates. Even though some US commentators argued that interest rate increases wouldn’t dent the US economy in 2019, that’s not what is at issue here. Higher interest rates means higher discount rates in valuation models. The impact of increases in discount rates are greater when rates are low. In 2014, Bernanke talking up how the Fed was going to start increasing rates led to the taper tantrum, which in turn led the central bank to make clear it was not doing anything anytime soon in order to appease the Market Gods.

The stock market in the US got a lease on life due to Trump. Running large deficits, even if they are due to some degree to tax cuts that favor the rich and are therefore inefficient, is still stimulative. His tax “reforms” boosted corporate earnings. The repatriation of profits stashed in foreign tax havens fueled buybacks.

The problem that the monetary authorities have gotten themselves into is that by over-relying on inflating asset prices and by depriving savers of safe sources of interest income, they’ve painted themselves in a corner. They need interest rates at something approaching an old normal level of short-term interest rates at 2% or higher, so they have room to cut them in a crisis or downturn. So the Fed is willing to use any sign of life in the economy to raise interest rates, probably figuring that one notch up or two too early won’t do much damage and they can ease off if they’ve overdone.

Another factor that may make monetary officials and regulators complacent is that at least in the US, they do seem to have moved some risks out of the banking system. But that doesn’t mean they are gone, but are in the hands of other bagholders. Banks take less trading risk than they used to. Critically, the Fed now backstops. the repo market, the source of short-term liquidity for capital markets firms. The repo market seizing up during the crisis, as one market participant put, it, was like opening the seventh seal of the Apocalypse. Derivatives clearing risk has also been moved to a significant degree into central clearing houses.

In other words, in the runup to the crisis, it was clear that a big problem was that both key markets and key players were too tightly coupled with each other. The Bank of England’s semi-annual Financial Stability reports clearly identified sixteen large financial institutions that were central to trading markets and whose impairment could transmit to the others. Lehman and Bear Stearns were both on that list. The Bank of England also did a fine job (given the lack of good data) of quantifying CDO and CDS risks.

In other words, some authorities before the crisis had a good handle on the dangerous exposures and the vectors of contagion, even if they didn’t know what to do about them. I would not include the Fed or the Treasury. It was shocking to see Bernanke, Geithner, and Paulson go into “mission accomplished” mode after the Bear rescue, when Bear had to be salvaged because it was a major CDS player and no one wanted to risk cascading defaults. Yet the US trio had no interest in understanding, let alone getting in front of this problem, even after having a live demonstration of what a danger it represented.

So even though the authorities may have succeeded in moving risks out of the heart of the US financial system, that may not make as big a difference as they’d like to think. The S&L crisis, after all, involved thousands of small institutions, none of which individually were critical, but collectively, they were a big problem.

In the US, the big stuffees include long term investors like life insurers, pension funds, and retirees, who have faced the ugly choice of sticking with sorta-safe investments and getting way too little in income or return, or walking on the wild side. The problem, of course, is that higher risk investments take a bigger hit than safer ones in a rising rate environment. It is also uncomfortably hard to judge the risks of BlackRock, where a big concern is its ETFs.

It also isn’t clear how well central clearing houses will work. The dirty secret is they can’t have large enough margin and other risk reserves because charing enough to cover default risks would make many derivatives uneconomical. That means the odds favor, eventually, that one of them will keel over. In theory, the clearinghouse is allowed to rip up customer trades. That might be acceptable in an event like the famed flash crash. But otherwise, this would seem to mean denying customers’ profits to save losers. And would the clearing hose operators be willing to make that call, or would they instead seek a rescue?

Recall these decisions can come too fast to be made well. A story we think can’t be told often enough: In the 1987 crash, the Chicago MERC almost failed; it was saved only with a three minute margin by Continental Illinois CEO Tom Theobald being in the office early and overriding an internal (and procedurally correct) order to not fund a $400 million loan against a failed customer order. John Phelan, head of the NYSE, said if the MERC hadn’t opened, the NYSE would not have opened, and if it has closed, he was not sure it would have been able to reopen.

And would Theobald have made that call if he had been running a privately owned bank? Continental Illinois was still under FDIC resolution. It took over seven years for the Feds to get out of the Continental Illinois business.

However, even thought the next crisis might produce a zombified economy in the US, overconnectedness is very much alive in the Eurozone, where wobbly banks (the Italians and DeutscheBank) are too connected to each other and to sovereign bond markets. And unlike the US, where despite whinging, the authorities have increased their rescue powers through the Fed’s reverse repo facility, the EU appears to have gone firmly in the wrong direction, as in making it harder to salvage banks. That might have been tolerable had the authorities forced the financiers to greatly strengthen their capital bases. But that didn’t happen either. In fact, the US went further in that direction than Europe did. The EU is left with nation states with inadequate deposit insurance schemes, some use of so called contingent securities, in which bonds can become equity or equity-like, an idea which has proven to make bank liquidity worse when they look shaky, and other bail-in approaches, which are pretty much assured of causing bank runs if they were ever to look like they might be relied upon. So the Eurobanks look like a time bomb, and more problems in Italy or a crash out Brexit, which would whack UK banks first but almost certainly afflict their Continental cousins soon enough, are possible triggers. Oh, and for sake of space, we’ve skipped over emerging markets, which are already blowing up, and China, which so many experts have said must have a crisis that they sound too much like the boy who cried “wolf,” even though he was eventually right.

So things look plenty precarious overall, but when and how things go critical is still anyone’s guess.