Commentary on Political Economy

Tuesday, 30 March 2021


Connecting the dots: Explaining the strange behaviour in markets

One of the more interesting questions that have flowed from the instant implosion of hedge fund Archegos Capital management is whether there are more accidents in waiting out there to tear new holes in big bank balance sheets.

At this point there doesn’t seem to be any evidence of contagion – the dumping of $US20 billion ($26 billion) of Archegos-related shares and the losses of up to $US10 billion incurred by a handful of global banks don’t appear to have had any material flow-on effects to other funds and banks. (That doesn’t mean, of course, that there aren’t more Archegos out there).

Sharemarkets are at record highs in the midst of a global pandemic.

Sharemarkets are at record highs in the midst of a global pandemic.CREDIT:AP

There may, however, be a loose connection between Archegos and other seemingly unrelated recent events, like the GameStop imbroglio, or Greensill’s collapse or even the extraordinary surge in the bitcoin price this year. The dramatic rebound in sharemarkets in the midst of a global pandemic might also be regarded as fitting within a pattern.

Archegos was a $US10 billion hedge fund with, it appears, at least $US50 billion of sharemarket exposures held via total return swaps, or derivatives. It effectively collapsed the moment it failed to meet a margin call and its banks dumped their collateral.

GameStop, where the price soared, and then imploded as retail investors attacked a hedge fund’s short position, also involved margin loans and derivatives, with the primary platform for the short squeeze, Robinhood, providing unsophisticated investors access to margin loans and options.

Greensill, operating in an obscure corner of the financial sector – supply chain financing, or reverse factoring – failed for an apparently different and more conventional reason. It extended credit to poor quality borrowers, with losses flowing through to other financial institutions because it had securitised and sold much of the funding to investment funds.

Bitcoin’s price has surged from just over $10,000 a year ago to more than $77,000, with the price rise accelerating since the start of this year (it ended last year at $37,653) while the US stock market is up more than 50 per cent in 12 months and about 72 per cent since its low point at the height of the fears of the pandemic in mid-March last year.

Another phenomenon of the past year has been the growth in the number of SPACs – special purposes acquisition vehicles analogous to the “cashbox” companies, or companies with cash looking to buy something, discredited here after the 1987 sharemarket crash.

There were four times as many SPACs listed in the US last year as any previous year, accounting for roughly half - about $US80 billion – of the money raised in initial public offerings.

What could connect such a disparate group of incidents and developments?

Two things: liquidity and leverage.

When you’ve got tens of trillions of ultra-cheap dollars flooding the global financial system it shouldn’t be surprising that they find their way into some odd corners, enabling behaviours that would have been perceived as overly risky in a pre-pandemic, let alone a pre-GFC environment.

The three major central banks – the Federal Reserve Board, the European Central Bank and the Bank of Japan – expanded their balance sheets by about $US8 trillion last year in response to the pandemic.

Balance sheets that still contained legacies from their responses to the 2008 financial crisis were swollen by 76 per cent (the Fed), 63 per cent (the ECB) and 29 per cent (BoJ) respectively, pumping torrents of liquidity into the global system even as those central banks, and others reduced interests rates to close to zero or below.

Not surprisingly, given that it was intended, global leverage has soared. According to the Institute of International Finance global debt has increased $US24 trillion over the past year with half the increase accounted for by governments’ fiscal responses to the pandemic and the other half by increased corporate, bank and household debt.

It says the debt binge increased the global debt-to-GDP ratio from 320 per cent to 355 per cent – a far larger increase than experienced during the financial crisis in 2008. The ratio increased 10 percentage points in 2008 and 15 percentage points in 2009.

The Bank for International Settlements has said that lending to the private sector in the US is more than 160 per cent of GDP, a peak matched only, and only momentarily, during the financial crisis.

Margin lending has also soared. According to the US Financial Industry Regulation Authority margin loans have increased from $US479.3 billion a year ago to more than $US813 billion, or about than 70 per cent, outstripping the growth rate of the sharemarket.

At the end of last year Robinhood, a platform with 13 million users largely devoted to retail investors, had about $US3.5 billion of margin loans outstanding. In the middle of last year it had made about $US1.5 billion of those loans.

Credit Suisse has been hit hard by the Archegos implosion.

Credit Suisse has been hit hard by the Archegos implosion.CREDIT:BLOOMBERG

When you’ve got tens of trillions of ultra-cheap dollars (and euros and yen and other currencies) flooding the global financial system it shouldn’t be surprising that they find their way into some odd corners, enabling behaviours (like securitisation of reverse-factored debt) that would have been perceived as overly risky in a pre-pandemic, let alone a pre-GFC environment.

It should be noted that, by hedge fund standards, Archegos wasn’t especially leveraged. If the numbers speculated are correct, its total debts were “only” between about five and ten times the funds it controlled. Its particular issue appears to have been the concentrated nature of its portfolio.

The average hedge fund has leverage more than three times Archegos’ level, although many of those funds would be leveraging far less risky activity to amplify otherwise very modest and relatively low-risk returns.

These things are, of course, relative. What might appear low-risk today could very quickly become highly risky tomorrow.

Central bank policies since the financial crisis have been intended to encourage/force investors and businesses to take more risks to try to stimulate economic growth. The policies have had mixed, and at best modest, success and with interest rates in advanced economies at or below zero have essentially run out of steam.

The big fiscal stimulus programs – the Biden’s administration’s $US1.9 trillion “relief” program and the $US3 billion to $US4 billion infrastructure spending plan now being framed are the biggest – are providing an economic boost until the shorter term stimulus is withdrawn as the pandemic recedes.

US interest rates – the key to global interest rates – are creeping up. US ten-year bond yields momentarily hit 1.77 per cent on Monday – back to pre-pandemic levels - before falling back, slightly, to 1.72 per cent.

The US yield curve is steepening, with the market’s conviction that the monetary and fiscal stimulus of the past 12 months will rekindle inflation threatening to wrest control over rates from the central bankers and hand it to the “bond vigilantes.“.

Inflation, and even quite modest increases in interest rates, would have implications for the demand for credit and very adverse implications for those over-leveraged or over-exposed to assets whose values have been swollen by the tides of liquidity and the tolerance for ever-increasing leverage that have been the key features of the financial environment in the post-GFC era.

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