Cracks in financial markets fuel debate on whether the next crisis is inevitable

To paraphrase a quote by legendary investor Warren Buffett: It’s only when the tide goes out that you discover who’s been swimming without a suit.

In this case, the metaphorical tide represents the end of an ultralow interest-rate era in the U.S., with borrowing costs now rising at the fastest pace in decades due to inflation. The Federal Reserve’s main policy rate target appears to be heading next month toward 4%, a level that some say is enough to send shivers through the financial system. If it then heads for 5% — as expected by some at Deutsche Bank and SEI, an overseer of $1.3 trillion in assets — that could spell even more trouble for markets.

Much has been made about whether the Fed’s string of aggressive rate hikes might tip the U.S. into a recession, but there’s also concern about what they’ll do to a swath of asset classes. Cracks are already showing in everything from credit markets to mutual-fund flows; the dollar; mortgage-backed securities; and the implied volatility of bonds, stocks and currency markets, according to Guggenheim Partners Global Chief Investment Officer Scott Minerd. And so far, the Fed has only lifted the fed-funds rate target to a range between 3% and 3.25%, up from almost zero at the start of the year.

History shows that financial crises tend to develop as the result of the use of derivatives, though liquidity and leverage can also play a role. Panic in the U.K. bond market is one recent example: It was triggered by the new government’s tax-cutting fiscal policy plan unveiled on Sept. 23, leading to an unruly selloff in gilts as managers overseeing pension funds faced collateral calls.

See: Will something break? What’s next for global financial markets after U.K. meltdown

There are now questions about whether a similar event could occur in the U.S. Treasurys market, which has been plagued with liquidity concerns.

Read: The next financial crisis may already be brewing — but not where investors might expect and Bond markets facing historic losses grow anxious of Fed that ‘isn’t blinking yet’

“All sorts of people have been gaming low interest rates for some time, and it’s hard to know where all the abuses are,” said Marc Chandler, managing director and chief market strategist at Bannockburn Global Forex in New York. “When the tide goes out, we can see who is not wearing a swimsuit. It will shine a light on a lot of places that could be the source of financial risk.”

Whether that discovery process happens quickly or over time remains to be seen. For his part, Chandler sees the risk that the U.S. economy’s weakness in the first and second quarter translates into a “garden-variety downturn,” similar to those that prevailed prior to 2000, before a financial crisis hits. Yet he doesn’t rule out the possibility of an unexpected financial crisis that arrives with speed — like it did in the U.K. — ahead of any economic downturn.

“The odds of a financial crisis, I say, are greater the more the Fed hikes, the longer the Fed hikes and the more that inflation stays sticky,” Chandler said via phone on Friday. Nonetheless, “a crisis could hit with no warning.”

On Friday, U.S. stocks
DJIA,
-2.11%

SPX,
-2.80%

COMP,
-3.80%
tumbled to a lower finish in response to a still-healthy U.S. jobs report for September that all but ensures that Fed officials will deliver another 75 basis point rate hike in November, taking the fed-funds rate target to between 3.75% and 4%. Still ahead for next week is the September consumer-price index report, which traders expect will produce the seventh consecutive 8%-plus annual headline inflation rate.

The last big shock to hit U.S. financial markets was in March 2020, when the fast-moving COVID-19 pandemic sent investors into a panic and triggered an intervention by the Fed that drove borrowing costs down to almost zero. Interest rates stayed near zero until March of this year.

Prior to that, subprime mortgage woes and a crisis of confidence in global banks culminated in the 2007-2009 financial crisis and recession, the latter of which became the worst economic downturn since the Great Depression.

Siddharth Singhai, chief investment officer for New York-based hedge fund IronHold Capital, stopped short of saying that he foresees another financial crisis. Instead, he said in an email to MarketWatch on Friday, “we believe that certain financial institutions may be in trouble.”

“Capital adequacy ratios have been strictly maintained across most big banks,” Singhai said. “The trouble would be derivative books: They represent hidden leverage and these are very complicated black boxes…We do think it’s quite possible that derivative books will get some banks in trouble. It’s however impossible to say exactly since these books are black boxes and quite often the banks themselves can’t make sense of these contracts.” 

Check out: Banks dial up risk-taking in OTC derivatives trades by using many of the same non-bank counterparties, a study says

Meanwhile, Michael Franzese, head of fixed-income trading for New York-based market maker MCAP, said he’s confident a financial crisis can be avoided in the U.S. because “the powers-that-be would support asset valuations to protect the system” in the same way that the Bank of England did in September.

“If you look at how the English handled the gilt market and stabilized it by buying bonds, the market turned around fast,” Franzese said via phone on Friday. “I’m more worried about geopolitical developments and major countries posturing on nuclear capabilities, which concerns me more than anything in the financial system.”

Read: White House says no new intelligence led to Biden’s nuclear ‘Armageddon’ comment