Newly appointed Chancellor of the Exchequer, Jeremy Hunt, the fourth in as many months, has brought stability to UK financial markets. The pound has steadied, and UK gilt yields have come down from their recent peak. It has been a calamitous three weeks for Bank of England Governor Andrew Bailey as he sought to address the rapid increase in gilt yields. As gilt yields rose prices plummeted, leading to huge margin calls at UK pension funds. Pension funds have increasingly used their gilt holdings as collateral to earn higher income rates. So-called “liability-driven investments” have grown rapidly in popularity from less than half £500 billion to just under £2 trillion in less than 10 years. The rapid surge in gilt yields was on the verge of creating a UK financial crisis, before the BOE stepped in with unlimited purchases of UK gilts and the new Chancellor reversed Kwasi Kwarteng’s misguided budget.

However, deeper problems remain. The zero-interest rate environment which ensued in the decade following the 2008/09 Global Financial Crisis (GFC) and continued during the Covid pandemic, has led to excessive household leverage and the creation of a housing bubble. UK mortgage debt is higher now than it was in the US on the eve of the sub-prime mortgage implosion, which heralded the GFC. Ever rising home prices were affordable because mortgage rates were close to zero. However, mortgage rates are surging in line with rising gilt yields. Mortgage rates, which used to be close to zero are now above 5%.

The UK is not alone. Canada, Australia and New Zealand also suffer from domestic housing and credit bubbles, which are in danger of sudden corrections from the fastest increase in interest rates in 40 years. Sweden and Norway suffer from similar vulnerabilities, but this did not deter the Riksbank in Stockholm from raising its policy rate by a full 100 basis points at its last meeting. Interest rates across these countries will need to be gradual but this may not be possible while inflation keeps surging. At its last policy meeting, the Bank of England raised the base rate by 50 bps to 2.25%. Interest rate futures predict the base rate will rise to 5.25% by next May, despite the budget U-turn.

By contrast, the US spent the years following the GFC repairing its household balance sheets. The credit binge which led to the sub-prime crisis has reversed. As a result, debt and debt financing costs, as percentages of household disposable income are at multi decade lows, which suggests households will be able to cope with rising interest rates. At the same time there are no signs of a housing bubble. This means house prices are unlikely to drop and create stresses at household level or at the financial institutions holding the mortgage debt. Moreover, bank balance sheets are in rude health. The Eurozone, like the US, is equally able to cope with rising interest rates. While the energy crisis is particularly close to Eurozone countries, savings rates, household indebtedness, and home prices are all at their healthiest levels in decades. There are exceptions. Italy and Spain suffer from excessive government debt and elevated budget deficits. However, the Eurozone is generally free from structural imbalances.

With the US better able to withstand rising interest rates, the Federal Reserve may be less inclined to slow its pace of monetary tightening. However, its actions are causing global dollar liquidity to shrink at an alarming rate, at its fastest pace since 1938. The strong dollar is compounding the liquidity drain. Even Paul Volker, who presided over the Fed’s attack on inflation in the early 1980s with a peak fed funds rate of 22%, kept money supply growing at a minimum 3-month annualised rate of 4.8%. It is currently dropping at an annualised rate of 2.8%. As liquidity is withdrawn, the risk of a liquidity or solvency crisis increases. The risk increases in a non-linear fashion and could therefore strike with little warning.

The IMF warned last week in its twice-yearly Global Financial Stability Report that the stability of the global financial system has “materially worsened”. Tobias Adrian, head of monetary and capital markets at the IMF warned that “There certainly are many vulnerabilities out there… When interest rates increase very rapidly, these vulnerabilities are exposed.” Fractures have already started appearing. Credit default swaps, used to insure against Credit Suisse liabilities, have surged. The ECB in July launched the Transmission Protection Instrument to prop up sovereign bond markets of vulnerable member states. Italy’s bond yield spread over German bunds has surged over the past fortnight.

The biggest fracture so far has been the gilt market riot in the UK that began on 23^rd September. Although the UK’s problems are home grown, Fed policy could be the catalyst for a disorderly solvency crisis. A crisis in the UK or any of the other vulnerable economies, which MRB Research describes as the “weak links”, could ignite global contagion. The Fed’s mandate is primarily maintaining price stability, which means keeping inflation under control. However, it is also mandated to target full employment and to maintain financial stability.

The near financial accident in the UK may be enough to convince the Fed that it has to tread more cautiously with its hawkish policy stance. Perhaps it is the UK gilt riot that prompted global financial markets to rise sharply last week despite far worse than expected inflation data, if it means Fed chairman Jay Powell is tempted to call it a day on reducing money supply. Even in the robust US economy, stresses are growing. The US Treasury’s Office of Financial Research Financial Stress Index is near a two year high. The Bank of America’s credit market stress index is close to its critical level.