Kwarteng wins Financial Idiot of the Year as IMF warns on the dangers of debt and swaps… and Buttcon worth $1?

Blain’s Morning Porridge – 6th December 2022: Kwarteng wins Financial Idiot of the Year as IMF warns on the dangers of debt and swaps… and Buttcon worth $1?

“When the hurly burly’s done, when the battle’s lost and won…”

This Morning: Good is bad, and bad is good as Kwasi Kwarteng wins the Financial Idiot of the Year award as the IMF warns about the consequences and dangers of $80 trillion of hidden swap debt and rising global debt levels. Should we worry? Probably.

I’m looking at markets this morning and shaking my head… Nothing ever changes. US markets took at pasting yesterday on the back of stronger than expected data from across the US economy. It’s looking like any recessionary forces to hit the USA will be shallower and weaker than even the economic optimists expected. That’s surely great news?

Nope.

Because Good is Bad, and Bad is Good… That’s the way markets think and work. Bad economic numbers are perceived to mean the Fed will hold back on inflation busting rate hikes, while good data means the Fed has the freedom to hike rates further and still achieve the dream economic soft-landing. Simples! Makes perfect sense – markets’ playing what central banks might or might not do… the actual reality of a stronger than expected economy being utterly irrelevant.

It does feel like were in something of a hiatus till next week’s US inflation numbers, but which point we are really into the end game of 2022…

I had to switch off Bberg news this morning as some lady from a corypto-exchange earnestly explained how it might take longer for Buttcon to hit $500,000. Really? I will go with a prediction from Standard Bank that Buttcon could collapse to $5000 next year in one of their “surprise” scenarios for 2023. Why stop at $5000? Buttcon has zero intrinsic worth, value or utility and is only worth what the next idiot will pay for it.

Apparently, according to some hate-mail last week: such comments mean I am definitionally an idiot – says Crypto-Trading Strategies, a $1000 a month US newsletter. I haven’t actually been able to find it – so if anyone has a copy I’d like to frame it on the wall! If you give me one bitcoin today for $1, I will be delighted to sell it back to you immediately for $2 on a matched trade basis. And you think I’m the crypto market fool?

2022 has been a fascinating year..

So many things made it memorable: Rising bond yields? Inflation? The war in Ukraine sparking the global energy conflagration? Sliding equity valuations? The disruptive Tech Bubble Busting? Lots of stuff to think about – and lots of names who should have their names engraved in the market book of idiots.

In a hotly contested contest, I am going to propose Kwasi Kwarteng as Financial Idiot of the Year.

The wake up and smell the coffee moment of 2022 was the unprecedented collapse of the UK’s Virtuous Sovereign Trinity following the sheer stupid naivety of the Liz Truss/Kwarteng mini-budget on September 23rd.

It was staggering – the UK’s reputation for sound finances: a stable currency, a sustainable bond market and political competency was undone in less than 20 minutes at the dispatch box. The consequences will haunt the UK economy for decades – every single Brit will suffer for it.

Truss and Kwarteng blithely ignored any and all sound and sensible advice. (Patrick Minford and Crispin Oday definitely don’t qualify.) There were no checks or balances. We’d never seen anything like it – how a pair of financially illiterate, ideologically driven political “lunatics had taken over the asylum.” Their moment of financial arrogance triggered a collapse in confidence in the UK, crashing the oldest and once most secure government bond market, Gilts.

Kwarteng, the short-lived chancellor, old-Etonian and a chap whom a chum described as “as man so fond of his voice, he made his ears redundant”, was utterly blind to the consequences of his actions. Following his budget triumph, he went on to quaff champagne and celebrate with delighted hedge fund bosses – who smiled and laughed as their sterling shorts soared in value.

Kwarteng and Truss should be together in the Tower of London. Any financial institution that pays them a penny to listen to their words of advice or give a lecture, should face a shareholder revolt.

Consequences matter. What followed could have destabilised the entire global economy.

The Bank of England spotted and acted quickly to stem what threatened to become a systemic collapse across the pensions sector as levered Liability Driven Investments – leveraged plays on gilts – were left deeply underwater by market volatility in the wake of the mini-budget, triggering margin calls on the underlying derivatives, which could only be met by selling more Gilts into a crashing market. The Bank stepped into to provide liquidity and stem what could have become a global systemic crisis.

It’s a lesson referenced in a report by the Bank for International Settlements released yesterday on the sheer scale of hidden debt obligations across the “shadow banking” sector from FX Swaps, Forwards and Currency Swaps: Dollar debt in FX swaps and forwards: huge, missing and growing.

These swap obligations don’t appear on balance sheets, are missing from the published debt statistics, yet have the potential to rock global markets with upwards of $80 trillion of undeclared dollar debt. Non-US banks account for around $35 trillion of this hidden debt – double the amount of debt actually recorded on their balance sheets!

$80 trillion is a stunning sum of money vulnerable to the potential consequences of market crisis. The reason we don’t worry about it is because it’s considered generally “sensible” money – global financial firms hedging themselves on funding and lending transactions. Because its sensible money – not directly addressing risk or speculative investments, but simply “smoothing” financial flows.. how can it be a systemic market threat?

The LDI trades that nearly sank UK pension funds were also considered “sensible” money by many risk managers – who looked to underlying risk-free Gilts, rather than the systemic risks of market volatility, or what might trigger a crisis if a major counterparty failed or an event of sudden stupidity, caused a cascading series of failures in the market.

The global financial markets are a bit like our cardiovascular system. Its efficient operation depends on the arteries of finance being fit and healthy.

Most of these hidden “sensible” global swap obligations are to hedge dollars and much of it is very short term. 88% of swaps reference the dollar as one side of the trade. 70% of FX swaps are less than one week. 30% is overnight! Because financial firms are constantly rolling over their swaps, were the swap market to suddenly seize up, trillions of dollar swaps would be maturity-mismatched, triggering multiple secondary consequences in meeting obligations were the market to ever suddenly snap shut.

Think of a failure triggered by a crisis in swaps as a financial heart attack. If global markets were to be destabilised by a sudden dollar volatility event, perhaps a failure of a major counterparty, or even a cyberstrike on a central bank, the consequences of trillions of failed short-term obligations would be crippling across financial markets.

It’s nearly happened before. In 2008 (during the Global Financial Crisis following the collapse of Lehman) and 2020 (Covid), the Fed stepped in to open essentially unlimited central bank swap lines to ensure dollar funding squeezes did not cause a fatal aneurysm in the arteries of global finance.

It’s a problem of complexity. Complexity can be fixed – if folk actually understand how the machine works. It’s when they don’t that it goes horribly, horribly wrong.

Five Things to distract you from shouting at Kwarteng this morning:

BBerg              SPACs Collapse as $11 Billion of Deals Are Called Off Within an Hour

FT                    Germany confronts a broken business model

WSJ                 Stocks Slide After Strong Data on Factory, Services Sector

Torygraph       Toyota launches six electric cars as it backs away from Hydrogen

Guardian         Cost of traditional Christmas dinner food “rises three times faster than wages”

Shard Lightbite Podcast         What’s in Store for Big Tech

The giant US Tech companies, often referred to by an acronym as the “FAANG” stocks, having seen tremendous growth in both earnings and market value over the last decade, now face enormous challenges from a regulatory perspective and potentially from just being too big to grow. Like the dinosaurs…

Out of time, and back to the day job…

Bill Blain

Shard Capital