The writer is a financial journalist and author of ‘More: The 10,000-Year Rise of the World Economy’
The recent turmoil in financial markets is a sign of a longer term problem. More than a year after Russia’s invasion of Ukraine, inflation has proved to be far from transitory. That has meant government bond yields, while volatile, have shown no sign of dropping back to the historic lows reached in the past decade.
The knock-on effects have been seen in the past few weeks’ banking sector turmoil after losses on long-term bonds triggered the collapse of Silicon Valley Bank. The loss of confidence in the sector spread, leading to the takeover of Credit Suisse by UBS and an emergency funding deal for First Republic. It seems as if the great speculative era has ended, and a new phase, the great unwinding, has begun.
Finance is a Darwinian world in which participants must adapt their strategies to survive. In the great speculative era, the cost of finance was generally low or falling, and the price of assets was generally rising. A strategy of borrowing money to buy assets was the best way to prosper; hardly surprising that investment vehicles such as private equity did so well. By the same token, high nominal returns meant that clients were relaxed about paying hedge-fund fees and venture capital groups could also flourish.
It is true that this era was subject to the occasional cull such as the collapse of the dotcom bubble in the early 2000s and the financial crisis of 2007-08. But the speculative bug came back with a vengeance in the 2010s. Risk-taking just found new avenues to explore; cryptocurrencies and special purpose acquisition vehicles, the listed shell companies that raise funds and seek something to buy, are just a couple of examples.
But all that will change if the great unwinding takes hold. Interest rates and bond yields will trend higher not lower. Just as low bond yields resulted in an upwards repricing of risky assets, higher yields will cause a shift in the opposite direction. Borrowing to buy assets will be an extremely dangerous bet.
There was a massive example of a great unwinding between 1965 and late 1981 when the yield on 10-year Treasury bonds surged from 4.2 per cent to 15.8 per cent. The effect on risky assets was grim. The Dow Jones Industrial Average managed to break above 1,000 in 1972, but was still trading at near that level in 1981.
It is unlikely, but by no means impossible, that the next unwinding will be as long-lasting as that era. But possible calamities include the breakdown of globalisation as relations between the US and China become increasingly hostile, a slowdown in growth as the global economy struggles to reduce its dependence on fossil fuels, and political division in the US.
Even if those risks are avoided, we have seen signs of how a shift to the new era would be difficult for the financial sector. SVB had its own peculiarities, particularly its bet on long-dated bonds and its dependence on wholesale deposits. Credit Suisse, with its long history of scandal, was a particularly weak link among European banks. And is hardly surprising that there has already been trouble among institutions exposed to cryptocurrencies, a sector that has seen more collapses than the towers in a game of Jenga.
Higher bond yields also will cause crises in many other places. In the autumn, British pension funds were caught out by their use of liability driven investment, an approach that on the surface sounded risk-averse but which in practice turned out to involve leveraged bets on the bond market. Longer term, the Darwinian forces as well as regulatory pressures will force institutions and investors to adapt to the great unwinding.
The world may even return to the days when a reputation for prudence was regarded as a commercial asset. If that does happen, then the numbers of bankers and fund managers who receive multimillion dollar bonuses will reduce. If risk-taking is seen as a vice, rather than a virtue, behaviour will have to change.
Just as the authorities had to rescue a bank based in the libertarian enclave of Silicon Valley, many in the finance sector are now counting on the central banks to change the direction of monetary policy and allow the speculative era to have one last hurrah. It all depends on whether the US Federal Reserve perceives the need to avoid a financial crisis as greater than the need to bring inflation back down to target. In short, will Fed chair Jay Powell prove as steely an inflation fighter as his predecessor Paul Volcker?
philip.coggan@ft.com
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