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The sudden drop in the pound and the emergency intervention by the BOE are largely attributed to the release of Chancellor Kwarteng’s “mini-budget”, at least in the media. That gives the impression that the issue is exclusively a UK problem, derived from fiscal policy. But, that doesn’t explain why other central banks, such as the RBA and, most recently, members of the ECB’s governing council, would consider modifying their policy because of what is going on in the UK.

Although the precipitating event was the uncertainty in UK finances brought to light by the “mini-budget”, it brought to light another significant problem: Lack of liquidity. And that goes beyond the UK. With the BOE facing down hedge funds backed up by the Chancellor, the risk of a “black swan” event that could trigger a broader global financial crisis has become elevated.
 

The surprising remarks

At its last meeting, the RBA didn’t raise rates as much as expected, citing several reasons. Among them was the situation in the UK bond market. It didn’t really cause many alterations in the market, as the consensus at the time was that the BOE would handle the situation.

Earlier today, however, a prominent ECB hawk came out to downplay the aggressiveness of future rate hikes in the EuroZone. He suggested that a neutral rate could be around 2.0% for the ECB, well below rates already achieved by the peers. Although he didn’t comment on the UK situation directly, he echoed words by Spain’s de Cos yesterday, who warned that shocks for the downside scenario had materialized. What are those?
 

Where’s the money

European financial markets have already been facing a major issue that has necessitated bailouts: The energy crisis. Energy firms had hedged future contracts to maintain steady supply by collateralizing their holdings. The sudden spike in energy prices drained substantial amounts of liquidity as energy firms were forced to increase collateral to avoid margin calls.

A similar situation happened with the pension funds, which were forced to put up more liquidity to defend their hedges that were collateralized by UK debt. However, the sudden spike in interest rates suggested that there was very little interest in buying bonds. The combination of global uncertainty and high inflation makes holding debt and paying relatively low rates for extended periods of time a bad investment.
 

The potential crisis

“Liquidity” is what keeps the markets going. It means that if someone needs to sell an asset, there is someone who wants to buy it. That maintains stability. Because, if there isn’t anyone to buy an asset that’s for sale, then the price gets lowered until someone is willing to buy.

Rising interest rates drain liquidity because it encourages people to not hold cash. If there is a crisis of liquidity, it means that markets could suddenly fall, as the lack of buyers triggers stops, forcing the market down.

Typically, talk of lack of liquidity precedes a major market collapse and the need for central banks to step in. That might not be the situation at the moment, but given concerns over liquidity, central bankers might be more hesitant to continue tightening. Even if the data (such as inflation) indicate that rates should keep rising.

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