Tavi Costa: Credit bubbles always burst… A blow out in corporate default risk is the next chapter to unfold

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The next global financial crisis could be lingering around the corner

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Nevertheless, investors were still caught off guard when the financial crisis of 2008 hit. The complexity of the global financial system meant credit risk was hard to assess. In 2008, you may have thought the entity you lent money to was solid, but through special instruments and derivatives, counterparty risk blew everything up.

Fast forward to today, and the complexity of the global financial system is still not easy to assess.

There are so many fissures emerging in the global financial system that it is difficult to predict which issue will be viewed by economic historians as the tipping point for the next crisis.

Perhaps it will be the mortgage market. Mortgage rates in Canada, the United States and Europe have effectively doubled – or will soon. Buyers in the past few years are especially likely to run into trouble as they bought at prices inflated by artificially low rates. As mortgages are renewed at higher rates, household cash flows will be impaired and net worth will decline.

Hedge funds are always a good candidate for starting a crisis given the propensity of some of them to use leverage. Hedge funds are incentivized to take big risks. How much debt hedge funds are currently in is impossible to determine, but it’s safe to say that those that rely on heavy leverage could find themselves in trouble.

The deterioration of China financially seems to be coming to a head. Decades of debt accumulation in the Middle Kingdom and almost unfathomably bad investments are certainly cause for concern. The question is how vulnerable the rest of the global financial system is to China.

More broadly, a sovereign debt crisis in developing countries is a real possibility depending on how exposed the global banking system is to the economic crisis we are witnessing in places such as Sri Lanka. Governments whose populations are facing mass starvation will prioritize saving lives over timely payments to foreign bankers.

There are many situations that can trigger a financial crisis – when asset prices steeply decline in value, business and consumers have trouble paying debts, and liquidity shortages hit financial institutions.

But once begun, they follow a typical pattern of panic, fear, and a mad scramble by central bankers and policy makers. Some institutions will be affected more dramatically than others, usually resulting in some form of debt write-off and some creditors taking large losses.

Stock market: 2022 is exposing ‘freaky post-QE financial system plumbing,’ BofA says

The global research team at BofA Securities, led by Michael Hartnett, has navigated the curveballs thrown by 2022 far better than most. In their latest missive, Hartnett & Co. reflect on the “broken, freaky post-[Quantitative Easing] financial system plumbing” and throw down the gauntlet at the bottom-is-in crowd.

“We are tactical bears,” says BofA, recommending bets on lower stock prices and higher yields (particularly in the two-year tenor) into Halloween.

 

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