The market turbulence is not being driven solely by investors’ views of the outlook for US monetary policy. There’s the chaos in Congress: a shutdown of the US government averted at the weekend only hours before deadline and, on Tuesday, the forced removal of Kevin McCarthy as House Speaker at the instigation of his own Republican colleagues.

There’s also the yawning US federal budget deficit, forecast to reach $US2 trillion ($3.2 trillion) this US financial year, or about 7 per cent of GDP, which will need to be funded even as demand for treasuries from the Fed and other central banks shrinks.

The Fed is unwinding the bulge of securities in its balance sheet from its response to the pandemic and other central banks are trying to blunt the impact of the surge in the US dollar by selling some of their holdings of dollar bonds.

In the December half of this year, the market is being asked to absorb $US2.8 trillion of new and maturing treasuries. By itself, the sheer scale of supply may be putting pressure on the pricing of existing securities, driving their prices down and their yields up. (There is an inverse relationship between the value of bonds and their yields).

With real interest rates now significantly positive – the yield on 10-year inflation-protected bonds is 2.43 per cent – there will be real economic effects, which is why there is now a lot of discussion about what the bond market rout might break.

Loading

There is already considerable stress within the US commercial real estate markets, with higher interest costs overlaying the impacts of the pandemic and the significant levels of vacancy caused by the shift to working from home. Commercial property is particularly sensitive to material movements in interest rates.

Earlier this year there were runs on some US regional banks triggered by an earlier spike in yields, with unrealised mark-to-market losses on their holdings of treasuries raising fears of insolvency that, for three banks, were borne out. Within the commercial bank sector there are now more than half a trillion dollars of those unrealised losses on the banks’ securities portfolios.

Regional and local banks are probably most exposed to the continued tightening of US financial conditions because they are more vulnerable to runs than the Wall Street heavyweights and because they do most of the lending to the commercial property sector.

The markets are being driven by the bond market, where investors have bought heavily into the Federal Reserve Board’s narrative that US interest rates will remain higher for longer than either the board or investors thought probable earlier this year.

With an estimated $US1.5 trillion of commercial property borrowings – probably taken out during the era of negligible interest rates – maturing and needing to be refinanced by the end of next year, the potential for something destructive to occur is increasing as the bond market sell-off continues.

The simultaneous falls in both bond and equity markets and the impact that the spike in bond yields is having on the dollar could also be wreaking havoc with hedge fund trades, which tend to involve highly leveraged attempts to arbitrage different markets and securities.

Hedge fund and other shadow banking activity isn’t transparent but has increased dramatically as a result of the more onerous regulation imposed on banks after the 2008 financial crisis. Macquarie has estimated that commercial banks now originate less than 40 per cent of credit.

With asset prices under pressure, higher funding costs and system liquidity being drained by the central banks’ unwinding of their pandemic period monetary expansions and by the strength of the US dollar, it is within the shadows of the system that considerable – but largely unidentifiable – risks might lie.

Loading

High-yield (junk) bond markets, private credit and leveraged securities don’t appear to have been affected materially by the rise in interest rates but could be another source of instability, particularly if the rise in rates chokes off economic growth and pushes the US into recession.

The centrality of the US bond market, the US dollar and the US economy to global financial markets and other economies and the prevalence of cross-border hedge fund trades means that if anything of significance breaks within the US system, there are likely to be ripple effects, at the very least, elsewhere.

The markets and economies do, of course, have a backstop. In recent decades, whenever there has been stress in financial markets, central bankers have scrambled to respond with “whatever it takes” mindsets.

There is no reason to believe that “put option” has expired. If cracks do appear in securities markets or the real economy, the Fed’s “higher for longer” narrative will instantly be displaced by interest rate cuts and torrents of liquidity from the reopening of the monetary spigots.

The Market Recap newsletter is a wrap of the day’s trading. Get it each weekday afternoon.