Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Karen Petrou is managing partner at Federal Financial Analytics and the author of ‘Engine of Inequality: The Fed and the Future of Wealth in America’
In the midst of chaos there is always volatility, and the commodities sector is very much feeling the pain. This has led to growing speculation that central banks will step in if unprecedented price swings show signs of systemic impact. I do not know any central banker who wants to bail out commodities, but if market stress turns systemic, they will act. Indeed, even if the stress seems manageable, they may intervene if they believe public welfare is at risk when core commodities go from pricey to prohibitive.
In the US, the Federal Reserve will resist calls to backstop commodities groups or traders for as long as it can by citing what it believes to be its limited mandate on prices and employment — even as it argues that its anti-inflation policies will stabilise markets. But whatever it is able to do about inflation will take time, and whatever it does will also exacerbate commodity market stress.
Although commodity markets are now largely back within the guardrails following the shock of the pandemic, Russia’s invasion of Ukraine sharply increases the odds for policy interventions that drive market risk to unprecedented heights. Three sources of structural financial market risk are particularly worrying. Even if none of them stokes central bank intervention, each will surely spark a new round of systemic regulation. The lessons of this crisis build on those that were hard learnt during Covid-19 and the 2008-09 financial crisis.
First, there is the liquidity stress brought by clearing house demands for collateral. This triggered energy traders to write to the European Central Bank last month, and it is just as serious in the US. The more commodity market volatility there is, the higher the clearing house margin demands and the harder it will be for traders to comply with them.
Although banks are now giving commodity traders some of the liquidity they need, there are signs the dash for cash is accelerating as a result of the same margining pressures highlighted in global regulators’ analysis of the 2020 Covid crisis, along with the Fed’s assessments of potential systemic risks.
Clearing houses did fine in 2020, even though the market froze so hard that trillions of taxpayer dollars were mobilised. This could happen again or, in a new twist, banks providing market liquidity could get their fingers burnt.
The second risk resides in balance sheets all over the world, mostly hidden from view. Eerily reminiscent of the collapse in the 1990s of Long-Term Capital Management, the implosion of hedge fund Archegos last year was a lesson in how seemingly small exposure to leveraged speculators can cost systemic-scale banks serious money.
The third risk resides even more directly in big-bank balance sheets. The capital framework for market risk dates back to 1996. Regulators then and now rely on value-at-risk to decide how much capital banks must hold against their trading-book exposures, even though VaR fails to factor in extreme-stress events. Big-bank stress tests in the US measure some market risks, but none approaches the price volatility of current core commodity markets or its downstream credit risk.
Clearly, this is a lot of stress for a financial system in the midst of a geopolitical crisis for which no one was prepared. Any additional market disruptions that even approach systemic thresholds will have profound impacts on public welfare. Millions across the world may find it impossible to feed their children, and the work essential for economic stability will be out of their reach. Millions more will reduce their spending to handle basic consumption.
So acute financial-market strain — even if not systemic — will have far-reaching social and public-welfare costs, with grave political consequences for governments and central banks that look the other way. The Fed will not seek shelter under its dual mandate and inflation-fighting assurances — doggedly clocking careful rate rises and cautious portfolio cuts — unless or until everything around it disintegrates into macroeconomic collapse and political fury.
As with inflation escalation beyond Fed control, the commodity speculation is partly of the central bank’s own making, after years in which its bailouts saved financial markets but only the largest banks were meaningfully regulated to prevent recidivism. We must figure out better ways to ensure macroeconomic and financial stability without moral hazard, but a geopolitical crisis is not the time to experiment.