Introduction:

Tuesday evening, futures markets traded down on news that Apple was seeing lower than expected demand for the new iPhone.  On Wednesday, the markets rallied with the S&P 500 up 2.0% and the NASDAQ up 2.1%.  The reason was the Bank of England announced they would buy long-dated UK treasury securities.  The BoE made some noises that it wasn’t giving up on quantitative tightening to reduce the money supply in order to contain inflation.  However, it’s supplying liquidity to the long-dated part of the market and reducing liquidity to the short-dated part of the market.  Verbiage aside, this is not the QT we were promised.

 

The story of what happened is not only fascinating; but also, makes clear just how close the UK financial system was to collapse yesterday.  The BoE acted quickly because they feared that they were about to experience their “Lehman moment”.  That’s when the entire system starts to collapse and institutions fail.

 

Here’s What Happened:

Pension funds hold and invest assets so that when the owners of the pension retire, the fund can pay them a monthly stipend.  There are all kinds of pensions including “defined contribution” and “defined benefit” as well as various parties responsible for the payments and investment results including the pensioner, the pension fund manager, a corporation, or a government.  In the case of these UK pensions, there was a shortage of assets due to the decline in the bond market.

 

Because most pension funds need to make regular payments, they tend to hold a lot of bonds.  Over the past decade or so, interest rates have been incredibly low.  Less than a year ago, the yield on the 10-Year US Treasury was 1.3%.  Even more remarkable, less than a year ago, the UK 30 Year Gilt (the UK version of a Treasury Bond) traded at a .8% yield.  That shouldn’t be possible.  Given any inflation at all, you’d be buying a financial instrument with a negative real return for almost a third of a century.

 

Two things happen when yields get that low.  First, it becomes very difficult for pensioners to safeguard their retirement using bonds.  How do you retire when you’re earning around 1% on your funds and inflation is running much higher than that?  This is also a challenge for the pension funds and it brings us to our second problem.  As bond yields fall, the value of the bond itself rises.  (The yield and the price are inversely correlated.)  That means that the pension funds had to own bonds at higher valuations.

 

Over the past decade, there have been countless articles on the risks of running a zero (or negative) interest rate, and we’ve been regularly critical of central banks for pursuing this dangerous policy for so long.  As inflation began to spike in the last year, central banks started to raise interest rates in order to address rising prices.  As interest rates rise, the value of the underlying bonds falls.  The pension funds that had to own a lot of high-priced and low-yielding bonds had to mark down their existing portfolio.

 

What happens next is the UK version of a capital call.  The pension funds were under-capitalized and had to sell assets.  Selling the falling bonds was difficult because volume in that market has been low for the past few years and multiple pension funds had the same problem.  Everyone trying to sell at once was likely to lead to a market crash.

 

The alternative was to sell other assets.  Again, the problem is when multiple sellers need to get out immediately without regard to valuation, that can cause individual stocks and the entire stock market to crash.  Program trading and stop loss plans can add to the momentum because once a stock falls by a defined percentage, other owners will automatically sell the stock adding to increased selling pressure.  Once that happens, the pension funds that were selling due to falling valuations in their bond portfolios now have to sell more due to falling valuations in their stock portfolios.

 

Selling leads to lower valuations which leads to more forced selling.  As the cycle repeats, the risk of a market crash increases prompting the previously discussed “Lehman moment” when the whole system collapses.  If any of you are thinking that this all seems remarkably similar to 2008, that the system is still being run by the same people with the same risks, and that we have unintended consequences and moral hazard due to governmental manipulation of the markets, then you understand exactly what’s happening.

 

Here’s Why the Market Rallied:

In the US, markets have rallied every time traders have thought the US Federal Reserve had over-corrected and was nearing peak tightening.  The assumption seems to be that normal conditions consisted of zero interest rates combined with unlimited quantitative easing (or money printing) every time the market dipped.  Recent higher rates were only a temporary stop on the way back to zero.

 

The Bank of England became the first of the major central banks to essentially throw in the towel.  In order to prevent a potential and total collapse of the pension system (and possibly, the stock market as well), they committed huge amounts of capital to buying 30-year bonds.  Yesterday, the market saw this as UK central bank capitulation and started projecting a near-term future where the European central bank and the US Federal Reserve followed suit.  People were excited about getting the low-interest rate QE (quantitative easing) party started again.

 

Stocks and Bonds Now Positively Correlated:

One thing that’s causing problems in some pension funds as well as the portfolios at some good Registered Investment Advisors is stocks and bonds are typically negatively correlated.  That’s just a fancy way of saying when bond prices fall, it typically causes money to flow out of stocks and into bonds.  The opposite is true as well.  This year, higher bond yields are being caused by high inflation and rapid central bank tightening.  As we’ve continually discussed, these Fed rate hikes are causing stocks to fall.

 

That means that both stock and bonds have been falling all year.  This kind of correlation has happened before, but the magnitude in 2022 has been extraordinary (meaning stocks and bonds are both down a lot).  That’s made it hard for anyone whose plan for a balanced portfolio was some sort of 60/40 allocation between stocks and bonds.  They’re losing money on both sides and other than owning energy or shorting the market indexes as DKI has recommended, there haven’t been a lot of good places to hide.

 

Liquidity is Gone:

Another factor contributing to yesterday’s near-disaster is central banks have taken over so much of the trading in government securities that there’s little private market volume.  In Japan, there are few trades in their version of the treasury market made by non-governmental parties.  Part of the problem the UK pension funds faced was a bond market that was not only declining; but also, had very little volume.  Trying to sell into an illiquid market can be impossible; especially if you need to do so immediately to address a capital shortfall.  Again, no lessons have been learned from 2008, and the entire system is being run in the same way by the same people.

 

Real Interest Rates are Still Negative:

Yesterday, the ”sentiment is too negative” crowd on FinTwit (financial Twitter), had a field day crowing that the financial tightening was overdone, the market was too negative, and their positive view of stocks was now deemed correct.  While many in this crowd are smart people whose work I read and respect, Deep Knowledge Investing has held a different view all year.

 

We’ve been clear that real rates are still negative and low by historical standards, that the Fed balance sheet is still enormous at $9 trillion, and that central banks all over the world have blown up a free-money bubble that’s too big to contain.  We think the central banks are trapped between inflation that’s crushing people’s living standards which will dry up saving and investment, and raising rates into a recession causing gigantic evaporation of household wealth.

 

The Entire System is That Fragile:

We believe the reason the market indexes fell today by more than they went up yesterday is because people started to realize how close we came to the implosion of one of the world’s largest and most prestigious financial markets.  The Bank of England is the world’s oldest central bank, and London has been a world financial center for centuries.  In a day, the market went from “the zero-rate party is restarting” to “did we just see a desperate diving catch to prevent one of the world’s premiere financial markets from collapsing yesterday”.

 

Conclusion:

The wild swings in market sentiment in just one day is why we were non-responsive and didn’t panic cover yesterday.  That’s also why we’re not taking a victory lap today.  We continue to believe the financial system could face a lot more pain before central bank actions improve the situation, and we continue to respectfully read the considered opinions of those who have a differing view.  Things can shift quickly and a financial center the world has relied on for centuries almost imploded overnight.  Alternatively, the quick shift could be central banks changing to a dovish stance, and we’d have another round of asset inflation before a later collapse.

 

Whatever happens, it’s going to require moving quickly.  We’ll continue to monitor the situation and inform subscribers immediately if/when our position changes.  If you’d like to know what I’m doing in my portfolio, or how we’re reacting to these market moves in real-time, you’re welcome to subscribe here.

 

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