In the wake of unprecedented economic decisions, the consequences of extensive lockdowns and massive money printing are now manifesting. The fallout from these actions is finally becoming evident, and it’s not pretty.
Have you seen the latest consumer price index (CPI) data?
The report indicates that consumer price inflation, as reflected by the CPI, rose by 8.2 percent annually in September. Although this marks a slight decline from earlier months, the year-over-year price increase remains near a 40-year peak.
Investors in the stock market reacted with jubilation, as if they were unaware of the underlying issues. Following the CPI report, the S&P 500 surged more than 2.5 percent. Perhaps their excitement stemmed from the fact that inflation didn’t rise even more steeply.
However, the debt market’s reaction is of greater concern. In the wake of the CPI announcement, Treasury yields spiked, signaling that bond investors are bracing for additional rate hikes from the Federal Reserve. Many opted to sell, anticipating the repercussions of rising rates.
As interest rates climb, bond prices decrease—a fundamental dynamic that has persisted throughout financial history. This discordance is currently creating havoc for debt investors, as the value of their holdings diminishes rapidly.
What should investors do in this turbulent climate?
The rational course of action is to sell—before values plunge further. This creates a momentum that drives rates upward and bond prices downward.
At present, fund managers and bankers are rushing toward the exit, while also hoping for bailouts to cover their miscalculations. It’s a precarious moment for anyone invested in the market; vigilance is essential to avoid being caught in the chaos.
Herd Mentality
People often exhibit herd behavior, easily swayed in large groups. When individuals are part of a collective, they may act in extreme ways.
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
This observation by the 19th-century journalist Charles Mackay in his work Extraordinary Popular Delusions and the Madness of Crowds remains relevant today.
From religious gatherings to sports events, large crowds can lead to tragic human stampedes.
For example, on September 24, 2015, over 2,400 people lost their lives in the Hajj Stampede in Mina, Mecca, Saudi Arabia, when two large crowds converged on a narrow street, resulting in a horrific crash.
This catastrophic incident serves as a poignant lesson about the dangers of mass behavior.
The Impact of Rate Hikes
The financial markets often mirror the frenzy seen in large crowds, particularly when central banks induce volatility in the money supply and credit rates.
The interplay of fear and greed can lead to significant market fluctuations, resulting in manias, panics, and crashes that happen with alarming frequency.
When speculative positions accumulate on one side of a trade, they eventually reverse, often in tandem with shifts in interest rates, resulting in significant losses for those unprepared.
Understanding market dynamics can provide foresight. It’s vital to recognize that financial markets exist to match buyers and sellers at mutually agreeable prices—each buyer needs a seller and vice versa.
In recent months, the Federal Reserve has been aggressively raising interest rates to combat rising consumer price inflation—a phenomenon largely born from lockdowns and unchecked money printing that disrupted supply chains while inflating demand.
As interest rates increase, the damage to financial assets, especially in the debt market, intensifies. This inverse relationship means that as rates rise, bond prices fall, particularly devastating when leverage is involved.
The Dire State of Debt Markets
Earlier this year, asset prices for bonds and stocks reached their highest points before deflating. Price corrections can occur in orderly fashion or spiral into chaos. In times of panic, a rush to exit can escalate into a stampede.
UK pension funds, for instance, have leveraged their investments under Lary Fink’s liability-driven investing (LDI) strategies. Recently, they confronted the harsh reality of rising interest rates, leading to substantial collateral losses.
Falling asset prices triggered a wave of selling due to margin calls and forced liquidations, resulting in drastic price crashes. The Bank of England had to step in as a safety net.
This issue extends beyond the UK; German insurers, banks, and pension funds are similarly affected by rising rates.
Notably, David Goldman from Asia Times recently pointed out that “the spread between German government bonds (Bunds) and interest rate swap agreements surged past the previous record set in 2008,” while “the cost of hedging German government debt reached an all-time high.”
Italy is also facing looming challenges, needing to refinance €245 billion ($238 billion) in government bonds next year, coupled with €230 billion in 2024. Italian 10-year yields have jumped to 4.7 percent this year from almost zero.
In a disheartening turn, Japan’s benchmark 10-year bond went without trade for four consecutive sessions this week, following the Bank of Japan’s efforts to suppress yields through excessive money printing.
The situation on Japan’s 10-year bond has become so artificially structured that it dissuades investors, giving rise to disbelief in the market.
What we’re witnessing is the outcome of decades of excessively low interest rates that have transformed financial professionals into high-stakes gamblers. While the tables were tipped in their favor, the tide has now turned.
In the U.S., debt markets are similarly facing significant turmoil. According to ZeroHedge:
“Bloomberg’s measure of prevailing liquidity conditions in the US Treasury market is at its most stressed since the peak of the COVID lockdown crisis.”
“When Treasury liquidity was last this constrained, the Fed injected $1 trillion daily to stabilize the bond market and initiated $120 billion in QE to avoid a catastrophic USD short squeeze.”
Expect more bankruptcies, defaults, fund unraveling, and, ultimately, substantial bailouts.
[Editor’s note: In today’s landscape, unconventional investment strategies are essential. Learn how to safeguard your wealth and maintain financial privacy by exploring the Financial First Aid Kit.]
Sincerely,
MN Gordon
for Economic Prism
