(Bloomberg Opinion) -- Looking at the constant drumbeat of awful headlines from Ukraine, much chatter of a new cold war, the not-very-surprising surge in commodity prices and inflation rates that only go up, you might have wondered why stock markets appear so resilient and government bond yields have dropped so much in recent days. I say the answer is that the broad stock market indexes tell you little about how much European and U.S. banks are probably suffering and how much worse things may get.
My primary worry centers on the hugely important markets for credit in its myriad forms. Thanks to central banks pushing short- and long-term interest rates to nothing in nominal terms and much less than that in real terms, there has been a proliferation of corporate debt, much of it of startlingly low quality. Desperate for yield, investors have taken on ever more credit risk and liquidity risk. Issuance of bonds rated below investment grade in Europe and the U.S. rose to a record last year, according to Fitch Ratings. The market for private debt (also mostly junk and for which there is no public market) has grown tenfold in the past decade.
Liquidity even for publicly issued, decent-quality bonds is less than it seems. When things are going swimmingly, corporate debt is easy to buy and sell. When credit markets take a turn for the worse, liquidity turns out to be entirely ephemeral. This is due in part to reforms after the Global Financial Crisis that forced banks to take much less market-making risk (taking positions and putting their own capital at risk). Generally, they now just match buyers and sellers. If there is a bid elsewhere, they will facilitate a trade; if not, tough. The lower the credit rating and more esoteric the bond, the harder it is to shift elsewhere.
This is very important now because there are signs that credit markets are deteriorating, especially in parts of the emerging world. Yield spreads here have already widened by 200 basis points, or 2 percentage points, this year to about 580 basis points, according to the widely-followed J.P. Morgan EMBI+ Index. Not all of the widening is due to Russia, which only accounts for about 5% of the index.
Of course, the weakness that happens periodically in emerging-market debt doesn't always presage bad things happening in the developed world, but in this case it probably does. For one, anecdotal evidence suggests banks are slashing risk, and not just direct exposures to Russia. They are also dumping loans to companies that might have exposure to Russia or might have exposure to activities that while still allowed for now, such as energy imports, might get restricted. Given that everyone is in the same boat, the prices banks are receiving for these assets are probably dreadful and the losses for banks correspondingly large.
What is worrying is that this get-rid-of-unwanted-risk-at-any-price approach may be spreading to other markets, hence the extraordinary movements in government bonds of the past few days. Now, it could be that banks or other investors were having to replace positions they thought they had with Russian institutions that are now worthless. Or it could be that they are simply cutting risk willy-nilly. Whatever the truth, the fact that they have become so desperate to cover that interest-rate risk no matter the cost and at a time of rapidly accelerating inflation and negative yields when adjusted for inflation, tells you how worried bankers are at the moment.
Banks also seem to be getting nervous about the exposures of other banks. Who knows what losses others might have suffered? So far, worries about counterparty risk is only a shadow of early 2020 at the start of the Covid-19 pandemic, let alone in 2008 during the financial crisis. One way to see this is through the FRA/OIS spread, which essentially tracks the risk of banks relative to the expected risk-free interest rate over a certain period. The wider the spread, the greater the worries. In early 2020, this spread spiked massively before central banks led by the Federal Reserve put in place measures to calm such fears.
Another bit of financial plumbing tells a similar story. Cross-currency basis swaps measure the cost of swapping one currency for another over and above the theoretical cost. When worries about banks rise and demand for the U.S. dollar has a haven increases, the cost (generally expressed in negative terms) goes up. This measure often becomes more extreme at the end of the calendar year, when companies need to tidy up their books. But as with the FRA/OIS, this cost surged in the spring of 2020 before the Fed cut rates to zero and announced a number of currency swap lines with other countries.
I suspect that the next crisis, whether it happens sooner or later, will be a capital-markets crisis rather than a banking crisis. It used to be that banks provided liquidity to investors and markets, helping to cushion shocks. Now, at the margin, they take liquidity from markets. That will be a huge problem for investors who have spent much of the last few years building up positions in assets that they will find getting out of a lot more expensive than they had reckoned. And that's if they can get out of them at all.
More From Other Writers at Bloomberg Opinion:
- Money Markets Pass Their Stress Test -- For Now: Marcus Ashworth
- Matt Levine's Money Stuff: Uninvestable Markets Are Hard
- Dethroning King Dollar Won't Be an Easy Feat: Robert Burgess
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Richard Cookson was head of research and fund manager at Rubicon Fund Management. He was previously chief investment officer at Citi Private Bank and head of asset-allocation research at HSBC.
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