Stock market proverbs are often both quite accurate and quite amusing.
One of them applies particularly well to the current situation: the markets take the stairs to go up and the elevator to go down »
We just had a wonderful example.
Please consider the graph below.
From 2014 to the end of 2021, UK 10-year (Gilts) interest rates drop from 3 percent in 2014 to 0.2 percent during the Covid panic.
Suddenly, the one who had invested 100 pounds in a 10-year bond with constant duration saw his capital increase from 100 to 134 in eight years.
And in 8 months, our investor is at less than 100 (97.8), having had no way to get out “in time”.
We actually just had the bloodiest bear market since 1971 in government bond markets in pretty much every developed country at once.
The attentive reader of the IDL will recognize that I have been saying for at least three years not to have a single long bond either in the USA, or in France, or in Germany, or in Great Britain.
I may have been pessimistic a little too early, but I don’t regret anything, as the decline has been heavy, brutal and may not be over.
Which, at this point in the reasoning, leads to a few remarks.
- From 2014 to 2022, the long rates on the bonds of all the developed countries had seen their prices constantly manipulated by the local central banks, to the point that the insane budget deficits created in this period had been completely financed by the said central banks operating the printing money in overdrive.
- This means that the interest rates paid on these bonds were not “the price of time” determined in a free market between buyers and sellers, but a false price imposed by central banks for the benefit of local states, which which simply amounted to a 100 percent tax on savings if the rates were zero.
- Buying bonds at this false price meant being sure that as soon as the “central bank” buyer disappeared, the markets would return very quickly to the true price, which implied a considerable and very rapid fall in capital, and that is exactly what happened.
So what happened in Britain last week is perfectly normal and everything will be fine very quickly?
I’m not so sure, and here’s why.
- Imagine that you are the manager of a British pension fund which has to pay pensions indexed to the retail price index in Great Britain.
- Imagine furthermore that the regulations force you to have at least 40 per cent UK government bonds.
- How do you meet the obligation to pay an inflation-indexed pension if the 10-year rates are at zero and inflation at 2 or 3 percent?
Answer, you can’t!
And that’s where your real friends come in, the investment bankers.
What do they offer you?
Something very simple: thanks to their deep technicality and their knowledge of the markets, they have built structured products “that will allow you to earn two or three percent more, without significantly increasing the risk of your portfolio. And the poor manager to rush on these extraordinarily complicated products which nobody, and especially not the manager or his board of directors understands anything.
And I’m going to make a revelation to all readers.
Major financial crises destroy equity markets, but they rarely originate there.
In reality, all the major financial crises that I have suffered or studied in my career begin with a frantic search for higher profitability on the bond market, very often because the central bank has set rates too low.
Let’s go back to the great crisis of 2008 2009.
Mr. Bernanke keeps interest rates too low to “stimulate growth” which has never worked in history.
The interest rates on AAA bonds, that is to say of high quality, or on government bonds are too low for insurance companies and pension funds.
Never mind. Wall Street gets to work and, from rotten bonds, builds pyramids of instruments whose upper part will receive the AAA rating. How do they do ? They take several junk bonds and say that the first 10 percent of the payments will go on a new bond, which is then rated AAA and can be purchased by insurance companies.
Of course, when the recession comes, the underlying obligors don’t even pay 10 percent and default on the new instrument and we have a massive financial crisis that we haven’t finished paying for.
For those who are interested, I have described these manipulations in my book “Liberal but not a guilty coup” which you can order on the site.
What happened this time in Great Britain?
I simplify.
Investment bankers have come to pension funds and said, interest rates are zero. Sell call options on 10-year bonds that would force you to buy the bonds if rates went to 3 percent, for example, and we would buy those options. There is little risk for you because the rates will take a long time to reach 3 percent, and you will have plenty of time to unwind your positions. »
What was done.
Unfortunately, a new prime minister (Liz Truss) is appointed in Britain along with a new finance minister and the two decide that interest rates must return to market levels and suddenly the 10 year goes from 2 percent to 4 percent in a few days.
The pension funds are forced to buy the bonds at 3 percent, and they don’t have a penny.
They therefore sell what they can sell, shares, bonds etc… whose prices collapse and the markets enter an infernal cycle where the decline becomes unstoppable while the exchange rate collapses.
Panic at the Bank of England, which did not know that these extraordinarily speculative positions existed.
But where were the supervisory authorities, the auditors, the rating agencies?
To absent subscribers, I guess
And suddenly, the Bank of England must buy in disaster 70 billion bonds of the British government, failing which, the Crash was inevitable.
But to redeem these 70 billion, once once more, is to run the money printing press, which risks making inflation rebound higher and faster.
We are brought back to the previous problem.
To summarize, the scenario from cycle to cycle is always the same:
- The central bank is setting rates way too low.
- Long-term savings are no longer remunerated
- The managers of this long-term savings are offered miracle products by investment banks seeking to help them
- These products are exploding and pension and insurance systems are on the verge of bankruptcy.
- Investment bankers are getting richer.
- The central bank intervenes, and lowers the rates and we have once once more a false market price on the interest rates, which allows the investment banks to offer new miracle products to the poor managers, who moreover were replaced for being taken in.
And at the end of the process, the manager of long assets hires the central banker at the end of the latter’s mandate, to ensure him a peaceful retirement.
- Thus Bernanke saved the greatest American manager in 2009 at the time, by buying all his junk bonds from him, to find himself on the board of this same manager when his mandate expired.
- Thus, Mr. Draghi was appointed to the board of one of the most prestigious investment banks, following having “saved” the euro in 2012.
To regain our democracies, we must remove the control of interest rates and exchange rates from central bankers, and perhaps audit the operations of central banks in periods when we have had financial crises.
The results would be interesting.
