A taste of Debelle’s concern

WE have just experienced a sneak preview of a potential catastrophic event.

WE have just experienced a sneak preview of the potential catastrophic event that Guy Debelle, the assistant governor of the Reserve Bank, was describing earlier in the week.

And when you understand what actually happened in New York on Wednesday, it explains why our sharemarket ended in the black yesterday.

When disappointing US retail figures came out, many big bond investors were underweight US bonds, and believed they must buy, sending bond yields down. A large investor had taken out derivatives gambling that there would be little volatility. When bond prices began rising the punting institution panicked and began buying 10-year bonds to cover its position. The combination sent the US bond rates from 2.2 per cent to 1.86 per cent, a move not seen since the financial crisis. Later the yield jumped back to 2.12 per cent. The gyrations were repeated in equities, underlining how closely bond and equity markets are linked to interest rates and quantitative easing.

ASX boss Elmer Funke Kupper, has compared US quantitative easing to the world becoming addicted to a drug.

Whereas this week was about falling rates, the Reserve Bank and the ASX are describing a debt market scenario in which US and global interest rates are rising, creating sharp falls in bond prices.

The equity markets will be severely affected by such an event. On Wednesday when bond rates reached 1.86 per cent the Dow was down 2.5 per cent. What happened in New York was a minor version of the forces Debelle was describing in bonds. Indeed, the fall in equities and rise in bonds has kindled calls for “more drugs” — a continuation of QE that would delay the arrival of the higher rates scenario that Debelle and Funke Kupper are basing their warnings on.

But the forces were scary. In equities, buyers disappeared. As shares fell, people who had borrowed money on margin were sold out. Automatic selling orders were triggered. Derivatives, which dominate the volumes, saw institutions scrambling to limit losses.

At one point, while bonds were rising the Dow was down almost 2.5 per cent. Those events are what would happen if we had a major debt market crisis, except that the market protection mechanisms that worked this week might fail.

Debelle believes a number of inexperienced institutions are gambling to achieve yield.

I don’t think we are looking at the start of a catastrophic event, merely a warning of what could happen when eventually we decide to stop taking drugs.

Watch the full interview with ASX CEO Elmer Funke Kupper at businessspectator.com.au