The resignation of Liz Truss as UK Prime Minister has helped to restore calm to global equity, fixed income and currency markets. Whatever the merits or flaws of her ‘mini-budget’ (and the conclusions are probably more nuanced than many commentators believe), the general expectation for a return to more orthodox UK fiscal policies has reassured markets.
No matter how fleeting the recent UK ‘gilt crisis’, it served as a healthy reminder of the increased vulnerabilities to capital markets arising during periods of high inflation and concerted central bank tightening. As investor assumptions and strategies implemented during low (or negative) interest rates and amid abundant liquidity are swept away, fault lines related to excessive market positioning, unsustainable investment strategies, and overextended leverage become exposed. History provides plenty of examples about what can go financially wrong when monetary policy is tightened, and the speed and size of 2022 rate hikes should only make investors and other concerned citizens more cognizant of financial risk.
In various countries and regions, therefore, the UK experience raises the question, ‘could it happen here’? The best answer to that question is an anodyne ‘perhaps but not very likely’ reply. But that answer only narrowly addresses financial risk. In a broader sense, we should be on high alert.
To begin, it seems unlikely for political or institutional reasons that another country will fall victim to what recently toppled the gilt market, sterling, and the Truss government. Few countries, after all, have a similar starting point as Truss did, namely a parliamentary system that enables the government to push through unorthodox and hastily prepared fiscal expansion. The US, for example, faces the imminent prospect of divided government by January, when (in all probability) the Republicans will control the House of Representatives, if not the US Senate. Political gridlock will prevent much of anything happening on the US fiscal front over the next few years. In Italy, Prime Minister Meloni’s government, for all its extremist past and current rhetoric, knows that EU funding and the ECB’s bond-buying backstop for Italian government debt rest on playing by Europe’s fiscal rules.
But if one sees the UK crisis as arising out of policy conflict (in the UK case between expansionary fiscal policy and tight monetary policy), then it is possible to identify other risk candidates. For example, in Japan, easy monetary policy juxtaposed against global monetary policy tightening has resulted in sharp yen depreciation that is pushing up import prices and inflation, as well as eroding domestic purchasing power. Japan’s finance ministry has been concerned enough about the scale of yen depreciation to instruct the Bank of Japan (BoJ) to intervene. But yen weakness, if it persists, could raise questions about the BoJ’s focus on domestic bond yield targeting, which is the key underpinning for the Japanese government bond (JGB) market. If investors begin to doubt the BoJ’s commitment to large-scale bond purchases, a sell-off in JGBs could reverberate massively across already buckling global government bond markets.
Another potential source of policy friction is growing in emerging markets. Thanks to aggressive Fed tightening, most emerging currencies have weakened against the US dollar, leading to surging import prices (exacerbated by food and energy price increases this year due to Russia’s invasion of Ukraine) and accelerating domestic inflation. With some notable exceptions (e.g., Turkey), most emerging countries have responded with rapid rate hikes to curb inflation and contain inflation expectations. But as global growth slows, the pain of higher interest rates risks being compounded by weaker exports and hence sharper economic slowdowns. Will emerging economies have the political and institutional backbone to keep fighting inflation as growth slows and joblessness mounts? If investors detect hesitation, emerging currency depreciation could turn into a rout.
In the US, political gridlock might prevent an ill-timed UK-style fiscal expansion, but it could also raise concerns about the willingness of Congress to lift the debt ceiling. That has happened before when Democrats controlled the White House (under Clinton and Obama) and Republicans had a majority in the House of Representatives. Conventional wisdom based on those earlier occasions suggests that the Republicans will not engage again in government default brinksmanship, but does the conventional political wisdom take into account how partisan and radicalized the modern Republican Party has become?
And then there are the ‘known unknowns’—sources of presumed risk that could manifest in large-scale market dislocations. Recently, much focus has been placed on concerns about liquidity, including in the vast US Treasury market. Illiquidity in Treasuries might sound odd given the vast size of the market, but only to those without memory of the 1998 financial crisis, when illiquidity in US Treasuries resulted in significant spread widening between on-the-run (current issue) and ‘off-the-run’ (already issued) Treasury securities of similar maturities. Large-scale dislocations in Treasuries are possible.
Those concerns extend to the collateral role of Treasuries, which form a borrowing backstop for a myriad of less-credit worthy financial instruments and derivatives. If collateral supply shrinks, given a scarcity of eligible instruments, securities lending and derivative markets could become paralyzed, jeopardizing in cascading fashion broader capital markets activity.
Also in the category of ‘known unknowns’ are the vast credit exposures that have built up in recent years, for example, in China’s property sector, across many advanced economy housing markets, in the corporate sector, and in private credit markets. While the precise locations of financial risk typically vary from one tightening episode to another, a common feature of financial stress is that it is the by-product of extended, large-scale financial flows made when monetary policy was easy and credit cheap. Equally, as the IMF has recently noted, risks can be magnified by investment instruments, such as open-ended funds that promise investors daily or weekly liquidity despite being invested in assets that typically are difficult to sell (i.e., lending and borrowing liquidity mismatches).
In sum, the exact experience of the UK crisis will probably not be repeated elsewhere because of more durable political or institutional ‘guardrails’. But financial stress and crises are the norm when monetary policy is tightened. There are plenty of candidates for something to go wrong. Investors, policy makers and other interested observers would be wise not to declare victory in the wake of Truss’s departure.