Two events in the last weeks have shown how brittle markets have become in the cumulative tightening cycle of all central banks bar Japan. The oversized impact of central bankers fighting inflation and currency depreciation (as I have tried to describe in my previous piece for Times of Malta) in tandem has made markets increasingly accident-prone.

Such accidents can be triggered by unforeseeable technical events like automated sell orders, or forced covering of short positions, or, worse, by mere rumours. When, over a weekend in October, commentators on social media speculated that the Swiss lender Credit Suisse, hammered by successive lending losses and regulatory reprimands might be “on the brink”, investors rushed to sell its pummelled shares and bonds.

The cost to insure Credit Suisse’s debt soared. Now, CS is admittedly in dire straits, forced to cover its malperformance by selling the most successful parts of its investment banking operations. But to assume that a heavily regulated bank, sitting on 97 billion US dollars’ worth of capital and reserves, will be wiped out is not justified.

When the hapless British Prime Minister Liz Truss announced last month her willingness to cut the top income tax rate from 45 to 40 per cent and promised more tax cuts to come, the UK currency and the value of its debt fell like a stone. The tax cuts were notably unfunded and as such would have necessitated yet more fresh borrowing.

Yet the amounts involved were not large enough to insinuate that Britannia was sinking to the bottom of the sea any time soon. They were also by far smaller than earlier-announced energy support measures for households and businesses, estimated to cost 150 billion pounds or more, which were shrugged off by the markets.

Great Britain is sovereign of its own currency which it can print at will and as such can technically never default. The Guilt market started to tank when investors were rightly assuming that Truss’ fiscal largesse would have to be countered by the Bank of England with higher interest rates to fight the inflationary effects of yet more government spending. This triggered a chain of events which can illustrate the hidden dangers for financial stability everywhere.

Pension insurance companies selling defined benefit retirement are intrinsically a sleepy business. Forced by regulators to hold assets matching their future liabilities, they own long-dated gilts, at least in theory, as we will see. When interest rates go up, the accounting value of their bond holdings drops. But this does not matter, because the present value of their future payout obligations drops in an equal amount.

British pension insurers looked into the abyss of insolvency- Andreas Weitzer

Years of low interest rates would have made pension offerings increasingly unattractive. Who would pay 50 pounds today to receive a 100-pounds-worth pension 40 years later, for instance? To boost returns and value-for-money competitiveness, pension funds had to invest in more lucrative but risky assets like stocks and to handle the risk of a volatile and often growing funding gap.

Its sheer existence signalled “unfunded liabilities”, which was not really trust-building with regulators. In their accounts, this gap was growing with falling interest rates. While the residuum of obligation-matching bonds was actually rising in value, the ‘underfunding’ increased in accounting terms year on year, as lower interest rates meant a higher present value of future payout obligations.

To do away with this ugly disfigurement of the books, pension funds invested in long-dated bonds with borrowed money, or rather in derivatives imitating the desired strategy of increased bond investment. While interest rates fell, these bets made up for any funding shortfalls.

As interest rates over 2022 shot upwards, the cost to pension funds to secure against the risk of falling interest rates mushroomed. They had to sell valuable assets, mostly their gilts, to meet ever harsher margin calls. As gilts fell in value, even more gilts had to be sold compounding their devaluation. Within days, British pension insurers looked into the abyss of insolvency. The cost of borrowing for the UK government shot up. In precarious markets, minuscule events in obscure corners of finance can have an outsized, panicked impact.

We know how it ended: to stabilise the market rout, the Bank of England had to jettison its inflation fighting credibility by immediately announcing a new gilt-buying programme worth 65 billion pounds. Instead of tightening financial conditions as intended, it had to ride to the rescue of the UK’s pension industry. Financial stability took precedence over inflation fighting. The markets took it in their stride and the currency recovered.

Stricter banking regulations in the aftermath of the Great Financial Crisis made ‘systematically important’ banks much safer. They have capital cushions and lending guidelines which convincingly shore up their resilience. The Credit Swiss alarm is therefore implausibly overdone. Yet by making banks a much safer place, regulators have shifted financial risk into unregulated areas of finance.

Lending is increasingly provided by asset managers, private equity companies, smaller, less ‘relevant’ lenders and pension funds. Bond markets too have replaced bank lending to a growing extent. And banks are no longer in the business of market makers. They no longer hold securities for buying and selling on their own books and they are no longer ready lenders.

Their former regulars, like commodity traders and utility providers, have to fend for themselves, suffering liquidity chokepoints en route. Increasingly, state actors have to come to their rescue. Late in summer, the city council of Vienna had to save their predominant local electricity provider, who could not meet margin calls for hedging its fixed-price electricity deliveries anymore. The utility, even on basis of an otherwise sound business model, could not cope with its sudden liquidity crisis.

“As the tide goes out, we can see who was swimming naked,” iconic investor Warren Buffet quipped when the GFC wrought havoc in the markets.

This is the thing: as long as companies and businesses are still well-bolstered with liquidity cushions, we do not see who is naked. To assume it to be those who struggled in the last crisis, house owners, mortgage providers and – infamously – banks sitting on mountains of mispriced mortgage-backed securities, gives us a wrong sense of danger location, even though there are already signs of stress.

Corporations and sovereigns are carrying much more debt than even 15 years ago and their solvency will be questioned.

Possible trigger points are plenty. The liquidity mismatch of asset funds allowing for daily withdrawals while sitting on hard-to-sell, illiquid assets; private equity with infamously smoothed asset valuations; the eurozone. But the thing is: dislocations will start from unremarkable, inconspicuous everyday banalities.

Nobody is clairvoyant, least of all small-time investors like me. Yet my guess is that whatever the inflation endgame of central bankers, at the end of the day they will give precedence to market stability, as the BoE did this month. In such circumstances, it would be wise to bag high bond yields better now than never.

Andreas Weitzer is an independent journalist based in Malta.

The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.

andreas.weitzer@timesofmalta.com