There is a very real contradiction that has developed between monetary and fiscal policies in large parts of the world and it is that contradiction which the UK experience highlighted and which manifested itself in a plunging sterling exchange rate and soaring UK bond yields.

The Bank of England was forced to intervene,committing to buy £65 billion ($112 billion) of UK bonds in a temporary reversion to quantitative easing only days before it was scheduled to start quantitative tightening – instead of buying bonds it was planning to start allowing its bond holdings to run down.

In that light,the poorly-conceived UK tax cuts could be seen as a trigger event and also as an illustration of the volatility and risks confronting policymakers and investors.

That volatility is being driven by the Fed,which has raised US rates by 3 percentage points since March and has foreshadowed more to come. The Fed is also engaged in its own quantitative tightening program,having shrunk its balance sheet by about $US332 billion ($516 billion) since March. That process is continuing at a rate of $US95 billion a month.

The Fed is now committed to continuing to raise rates and withdraw liquidity from its markets until it brings its inflation rate (now 8.3 per cent) back towards its target of two per cent. In the process,however,it is exporting inflation and volatility to the rest of the world and having uncertain but material impacts on the liquidity of its own markets.

Traders in US government bonds are reporting that liquidity is as poor as it has been since the initial impact of the pandemic. Volatility in the bond market is as severe as it has been since March 2020.
With the meltdowns in the US and global equity and bond markets – the US sharemarket is down 25 per cent this year – a lot of cash is now sitting on the sidelines,adding to the illiquidity.

The UK experience exposed a previously little-recognised vulnerability in the UK financial system,the UK pension sector’s use of derivatives to help match its assets and liabilities.

When bond yields spiked massively in response to the Truss government’s tax cuts the funds were hit with losses on their positions and demands for collateral that could have rendered the sector insolvent almost overnight had the Bank of England not stepped in to support long bond prices.

Previous global financial crises have tended to start in dark corners of the system – like the US sub-prime mortgages market in 2008 or the Russian bonds crisis in 1998 that also blew up Long Term Capital Management – and the vastly increased financialisation of almost everything means the system is now as opaque and potentially dangerous,given the levels of global volatility and uncertainty,as it has ever been.

The Fed’s deputy chair,Lael Brainard,referred to the interactions between monetary policy and financial stability at a conference last Friday,saying that as monetary policy tightened globally to combat inflation it was important to consider how cross-border spillovers and spillbacks might interact with financial stability.

An increase in risk premiums,she said,could “kick of deleveraging dynamics as financial intermediaries de-risk” and shallow liquidity in some markets could become an “amplification channel” in the event of further adverse shocks.

The UK experience could be said to contain some of those cross-border spillover effects and was amplified by the shallow liquidity in its own and global bond markets.

It is no wonder there are frissons of fear coursing through financial markets,with investors and others searching for new flashpoints.

The social media speculation around Credit Suisse’s stability is a case in point.

There are a lot of potential flashpoints for a new crisis and the system will remain vulnerable until monetary policies within the major economies are more in sync and markets are more stable and liquid.

The Swiss banking giant’s share price has collapsed this year,tumbling 63 per cent. There’s no doubt that aftercostly debacles like Archegos Capital,where it lost $US5.1 billion andthe Greensill debacle ($US1.72 billion of losses),among others,the bank’s investment banking division has undermined its stability. Spreads on its credit default swaps (insurance against defaults) have blown out dramatically.

The bank spent the weekend trying to reassure shareholders,clients and counter parties that it has sufficient liquidity and capital to fund a restructuring after social media was (and is) full of damaging speculation (and lots of memes). Observers are searching for the next Lehman Brothers.

If history echoes rather than repeats it is probably more likely that any threat to global financial stability will,as the UK experienced last week,come from a collision at the intersection of global and local monetary and fiscal policies that exposes some previously unrecognised vulnerability within the shadows of the system rather than within a banking system that is more stringently regulated and far better capitalised than it was in 2008.

What is apparent,however,is that there are a lot of potential flashpoints for a new crisis and the system will remain vulnerable until monetary policies within the major economies are more in sync and markets are more stable and liquid. That could take a while and involve more moments like those the UK experienced last week.

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