A taste of the market meltdown to come

Last night we experienced a sneak preview of the potential catastrophic event that Guy Debelle, the financial markets assistant governor of the Reserve Bank, was describing earlier in the week. (Is Guy Debelle right? October 15.)

And in a fascinating KGB interview, the chief executive of the ASX, Elmer Funke Kupper, compared the current US quantitative easing to the world becoming addicted to a drug. The addiction is now so bad that we don't even realise that we are taking the drug.

Once again, we are seeing a sneak preview of what could lie ahead. But be careful. There are fundamental differences between what is happening now and the possible crisis Debelle and Funke Kupper are preparing us for.

The Reserve Bank and the ASX are describing a debt market scenario in which US and global interest rates are increased followed by sharp falls in bond prices which results in great damage being done to the derivatives markets, where there are high leverage positions in play. 

Debelle says that there may simply not be enough buyers to stop a free-fall. In the Reserve Bank and ASX scenarios, the crisis comes to the debt markets. The equity markets will obviously also be severely affected, but, they are not in the front line.

What we saw last night was a minor version of the meltdown Debelle was describing, though this one was playing out in the equity not the debt markets. Indeed, it was the reverse of what The Reserve Bank and ASX have been warning about -- US bonds actually rose in price as there was a massive flight to the “safety” of the US currency's government debt securities.

Indeed the fall in equities has kindled calls for “more drugs” -- a continuation of quantitative easing that would delay the arrival of the higher interest rate scenario that Debelle and Funke Kupper are basing their warnings on. And so, if anything, last night's events may actually help equity markets by delaying the introduction of higher interest rates

That said, the forces that Debelle described were there for all to see, albeit applied to equities not debt. Suddenly 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, the Dow index was down almost 2.5 per cent. Last night, the market protection systems worked and buyers came in, halving the losses. Those events are exactly what would happen if we had a major debt market crisis, except that in the full blown crisis that Debelle fears, the market protection mechanisms fail.

In other words, the buyers either don't come in or are swamped by a wall of selling. As a result, the markets will be unable to hold the debt security values.

The likelihood of this happening is increased because Debelle believes a number of inexperienced institutions have entered the loss protection derivatives market with exposures that they should not have embraced. They are currently gambling in a desperate attempt to gain yield. These institutions and their members will be hit very hard. 

Funke Kupper does not believe many, if any, Australian institutions are taking the derivative risks Debelle describes, but there is no doubt it is happening in the US.

I could be wrong, but 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.