IMAGINE how the financial crisis of late 2016 might play out. A surge in wage inflation, caused by a tight labour market, prompts the Federal Reserve to push up interest rates more quickly than the markets expect. Both government and corporate bonds fall in price.
That creates a problem for funds that specialise in corporate debt. They had promised investors that they could redeem their holdings at any time, but the corporate-bond market is very illiquid; many bonds prove almost impossible to sell. Some funds are forced to impose “gates”, limiting fundholders’ access to their money. The restrictions cause a panic among investors, who scramble to sell all bond-fund holdings. Prices plunge, in effect closing the market for new issuers: firms find it impossible to raise new cash. Rumours about financial problems at a big fund manager start to circulate.
That scenario seems to be at the heart of a weighty consultation document issued by the Financial Stability Board (FSB), an international body charged with preserving the health of the global financial system. Regulators, it is generally agreed, were asleep at the wheel in 2005-06, when the...Continue reading
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