[UK]A conjecture about the financial crisis in 2023
Author: Li Jianqiu
(https://mp.weixin.qq.com/s/rh9pwLuS6aG504KMZ694_w)
A fan has asked me to narrate the transmission path of a possible financial crisis. I will recount it.
Why next year and why not the past.
A strong 25 year old with the flu is not really that big a deal. An 80-year-old frail man with the flu could die. Successive financial crises, and the way they have been handled, have signalled problems with the financial health of the country and the world.
In the great inflationary rise of the 80s, the Fed could pull the base rate up to 15%, 18%, and now? It's only been raised so little and it's unbearable, the liquidity of US debt is drying up.
When dealing with the financial crisis in 2009, it could flood like crazy, how can it do that now?
In the past it was to be laughed at to say that the UK pensions were losing £500 billion because the UK changed its prime minister, but now it's happening.
So what will happen in the future?
We've seen a lot of bullshit about Powell, today he says he's going to tighten, tomorrow he says he's going to ease, and there's no truth to it.
Let's look at some values. Here is the Global Supply Chain Stress Index
The latest value is 1.2, which is still not back on track and could rebound at any time.
The CRB Commodity Index of 267.45 is still not low.
In particular, the CRB Food Index averaged 17.6% year-on-year growth through October, with growth rates picking up for the third consecutive month on a sequential basis. In addition, an ageing population, the aftermath of the epidemic, labour supply shortages and the wage price spiral effect continue to build momentum.
The US job vacancy rate has fallen back from a year ago, but is still 1.5 times the rate of the five years before the epidemic. The wage growth index has increased by an average of 6.4% over three months and 6% over 12 months, a new record high.
More problematically, in addition to core inflation, services such as "health care", "information technology, hardware and services" and "personal computers and peripherals" Inflation is also starting to spread.
The US pulled a lot of companies from Europe a while ago, which is normally a good thing, but at this point of labour shortage, I don't see it necessarily, with the labour participation rate instead falling back 0.1 points in November from a year earlier.
Too much has been recounted about the current inflation in the US to elaborate further.
A word about transmission.
Why it is the UK that suffers
Let's start with how the UK pensions plummeted some time ago. To be brief.
UK pensions are around £1.7 trillion, 65% of which is invested in bonds, the mainstay of which is UK Treasury bonds.
Pensions have fixed outgoings for the next few decades and need to hedge against the risk of asset volatility. The main means of doing this is to buy long-term treasury bonds, which generate interest income, and then enter into agreements with investment banks to pay floating interest and receive fixed interest in the future, in the process pledging the long-term bonds to the investment banks.
Then there is a significant interest rate increase in Europe and the US, the final trigger being Truss's tax cuts leading to a significant spike in interest rates, in which case UK bonds are sold off, prices plummet and the investment banks ask the pension fund to replenish the collateral.
At the same time, pensions pay floating interest rates, which have been greatly increased by the sharp rise in interest rates this year.
This would actually count as a loss at best at the accounting level, but the time to replenish the collateral is short, so in order to replenish the margin, fund managers sell off a lot of treasury bonds, causing the interest rate on treasury bonds to rise, which in turn drives up the floating interest rate paid, which in turn demands more margin payments.
More margin in turn necessitates the selling of more bonds.
It is a kind of death spiral.
Let me give you an example from A-shares.
In 2015, in 2016, A-shares fell off a cliff at every turn for a particular stock.
Why?
Shareholders pledge their shares, pledging them to banks in exchange for funds, and once they fall to a certain level, the banks will ask the shareholders to repledge them.
It takes money to replenish a pledge, and where does the shareholder get the money?
By selling their shares.
But selling shares will cause the stock price to fall further, leading the bank to ask for more replenishment.
So more shares are sold. Eventually there is no more to sell, and the bank, seeing that it cannot pay the margin, also starts to sell the pledged shares.
So a thousand shares fell and 2,000 shares fell.
The UK one was similar.
The financial markets are not afraid of a fall, they are afraid of this death spiral.
UK pensions hold a significant proportion of mortgage bonds, equity, shares in venture capital funds, real estate and many more illiquid assets in addition to treasury bonds, and asset prices have plummeted under the sell-off.
So it is a wonder that the Tories are still in power.
Transmission
This brings us to the link between Britain and America.
After the Second World War, a large number of Soviet dollars in the US were transferred to Europe, creating the first Eurodollars, and since then a steady flow of dollars has flowed out of the US, and because there is less financial regulation in Europe than in the US, many financiers have come to Europe from the US to seek gold.
A European dollar market was formed, the core of which was in the UK.
The relationship between Britain and the US is therefore very special.
If you still remember, you will recall that there was a similar problem in the US in 2020 to that of the UK pensions, when US stocks melted down three or four times, with the result that it was transmitted directly to Europe.
Because many asset managers have assets on both sides of the pond, after a liquidity crisis in the US, they would certainly sell off their European assets to protect the US.
After the massive sell-off, although it was the US that saw the meltdown, it was quickly transmitted to Europe, especially the UK.
Thus, between 28 February and 20 March 2020, there were several meltdowns in the US and, as a result, in the UK at the same time, while the A-shares, which have always been crotch-pullers, also fell at this time, but not as much as in the UK and the US.
Breaking point.
After sorting things out, we can imagine the following: after the Federal Reserve had released various easing signals intermittently, the market was paralysed, but at some point it was found that the US inflation rate suddenly increased significantly, and this increase could be due to various reasons, such as the sudden deterioration of the Russian-Ukrainian war, the sudden rise in energy prices, supply chain problems and various other factors.
The market panics, interest rates rise, bond prices fall and there is a sell-off.
The bonds were the collateral for the asset management companies and the collateral was sold off so much that the banks asked the asset management companies to replenish their collateral and the asset management companies had to sell other assets.
For example, UK assets, European assets.
Thus driving UK assets downwards, and not coincidentally UK assets are in turn collateral for certain UK asset managers, and the more they are sold off, the lower the price, which in turn goes into a death spiral.
This is not impossible, as it has happened before.
It doesn't even take much at all for a sell-off in US debt to trigger problems such as a corporate junk bond crash, or a real estate fund crash triggered by a real estate crash.
BlackRock suffered a run some time ago.
This time, when the British pension fund sold off many of its high-quality assets, it did so at a discount of 20% to 30% to US vulture funds.
What are the dangers of such a transmission?
Someone is bound to jump in and say: your scenario is overly complex and demanding, and it is perfectly possible to envisage a simpler, more explosive financial crisis with the current UK finance.
Yes, indeed, because it would actually require the UK and the US to have financial problems at the same time, and the financial links between the UK and the US are very close. A different country would not work.
But isn't that what happened? Coincidentally.
The advantages of envisaging it this way are as follows.
First, it is realistic, it is effectively a combination of the transmission from the US stock meltdown in 2020 + the UK pension collapse, it has happened, it is likely to happen again.
Secondly, it has an incomparable hazard. The danger lies in the fact that it was neither triggered nor solved by the UK, but it is precisely the UK that has suffered the most.
As mentioned above, when the US goes wrong financially, selling off British assets in order to preserve US assets will cause a sharp devaluation of British assets, which is an injury.
After the sale of British assets to obtain the pound, and then sell the pound for dollars back to the United States, the process, "sell the pound" itself hit the exchange rate of the pound, and just the exchange rate of the pound is already very fragile, this is the second injury.
At the same time, because the envisaged crisis is actually in the United States, so no matter what the Bank of England to do, can not stop the crisis, can only wait for the Federal Reserve to make a decision, which belongs to the insoluble nature.
There are two things that the Bank of England can do: firstly, it continues to release water on a large scale to take on the assets that are sold off and alleviate the pressure of the sell-off.
Secondly, declare a moratorium on free exchange between the pound and the US to reduce the impact on the pound.
Once the free exchange is suspended, it is tantamount to another cut on the pound.
So there is essentially nothing the Bank of England can do.