Panic station: Inside the bond markets
The eurozone is quaking, thanks to the men who control the $80 trillion bond market. At its epicentre is the Chicago Mercantile Exchange – when traders here are nervous, nations are rocked, writes Stephen Foley
Monday 07 June 2010
There is an angry mob out there. Its shape is dimly perceived, but the terrifying shadows cast by its burning torches are clear enough. This is the bond market in full cry.
Its most aggressive participants even call themselves the 'bond vigilantes'. Across Europe and into the UK, governments cower, populations are told to brace themselves for painful cuts, and austerity is the order of the day. In the US, too, their proscriptions are moving up the political agenda. Fail to assuage the mob, we are told, and untold horrors await, nightmare visions such as the flying apart of the eurozone, the ruin of the British Government's finances, or the final collapse of the US dollar's hegemony.
We are in danger of submitting ourselves to policymaking by fear. A world created in the image of the bond vigilantes is a vicious, reactionary place, to be resisted rather than embraced. And remember this, above all: the bond market is not always right.
What are we even talking about? How can we pin down this thing, this vast market for IOUs from which governments must finance their record deficits? We will all have to better understand the language – and the body language – of the bond market. James Carville, President Bill Clinton's sage old adviser, is often quoted. "I used to think that if there was reincarnation, I wanted to come back as the President or the Pope," he once said, "but now I would like to come back as the bond market. You can intimidate everybody."
It is not easy to anthropomorphise a financial market, and especially not the enormous and diverse bond market. There is no obvious, teeming souk to visit, where all of the world's $80 trillion of outstanding debts are bought and sold, as the action takes place at millions of terminals in financial institutions of all stripes and in all corners of the globe, and even inside pre-programmed trading computers. But there is a place where you can go to take market's temperature, to hear some of its voices, and to get the measure of a philosophy in the ascendancy. That place is in Chicago.
The Chicago Mercantile Exchange "is where the world comes to manage risk". That is the boast on the plaque inside its historic headquarters in the downtown heart of the third largest city in the US. The CME started life more than a century ago as the Chicago Butter and Egg Board, when financiers and farmers gathered to set prices for future deliveries of goods. These days it is a vast futures and options market, not just for agricultural products, but for other commodities and for financial derivatives tied to foreign currencies, to the stock market and, most importantly, to European bank debt and US government bonds.
Everything that happens in the bond market ripples through the prices of the contracts traded here, and everything traded here ripples back through the bond market. And it all happens the old-fashioned way: with men in coloured jackets shouting and making hand gestures at each other beneath an impenetrable wall of screens filled with numbers and codes.
This is an up-by-your-bootstraps place, full of independent traders and self-made men of scrappy backgrounds. This is the Midwest, not the East Coast. In many ways it defines itself in opposition to New York. Wall Street is where bankers dream up ever more exotic schemes to raise money and parcel debt around. Chicago is where traders assess the brutal question: what are my chances of getting paid back? Many traders here concur that Chicago is a financially conservative place. Yra Harris, a veteran of the trading floor, who runs his own firm, Praxis, and pontificates on the ills of Europe's economy on his blog Notes from the Underground, says it is because most of the people in the pits are trading their own money. "That makes you a much better risk analyst. When you work in bank trading you are trading other people's money; you learn a lot of bad habits. Some of the worst traders I know are bank traders, but they have the power of the mechanism behind them. It allows them to smooth things over. There's nothing better than being able to dump your worst positions on your customers. We don't have that ability. If you have bad habits here, you are not here for long."
With the world awash in debt, and governments needing to raise more and more to fund the stimulus programmes that kept the world economy from the brink in 2008, this place has never been more powerful, more self-confident or more assertive. It was from here – from the very floor of the CME – that the anti-government Tea Party movement sweeping the Republican party was launched. This is the story of Chicago rising.
Chicago is where the militant wing of the bond market can be found, and where its real world impact is magnified, thanks to the leverage that comes with trading derivatives (which allow you to place bets many times the value of the underlying bonds). The CME trading floor resembles nothing so much as a sports arena during a rowdy game. The litter of discarded trading cards is everywhere, the arena is filled with the babble and occasional roar of traders, each in a different pen, or "pit", according to the financial product they buy and sell. There are skyboxes for the media and executives; a mezzanine tier for brokers, who are tied to their phones and terminals taking the orders that they will signal for traders in the pits below to carry out.
You can literally see billions of dollars moving around here. First, a piece of news sending share prices higher will cause a frenzy of buying in the trading pit for stock market futures until, suddenly, a scary piece of news causes a jolt of buying activity in the supposedly safer investments available in the bond derivatives corner. It is a scene Ron Pankau has taken in every work day for the past 30 years. "This here is the reallocation of funds, all day long," he says. "Big institutions have to move so much money, there is nowhere else where they can do it so fast. Where else can you move $100m out of the stock market in 30 seconds? You wouldn't be able to do it in the real world of owning actual stocks."
Like the farmers who used the CME's forerunner to lock in prices for the eggs and butter they would deliver in the future, this is where investors come to hedge the risk of changing prices for government debt and other bonds, and changing interest rates. It is also where speculators come to gamble on those prices and rates. Speculators are the grease in the machine. Farmers needed financial speculators a century ago to make the market work; we need them now, too. One question is: do we need this many of them?
An independent trader and a thoughtful soul, Pankau has built a decent living here. Recently he has also taken on a second business, a little steel-making firm in western Illinois whose retiring founder was threatening to shut it down. He connects dots from the trading pits to the livelihoods not just of the 40 employees of his little venture but to the very health and vibrancy of the world economy. "The only reason the bank, Wells Fargo, lent me the money to buy the business is because they can hedge their risk here. The reason you are able to get credit to buy a Ford motor car is because the risk of your loan can be hedged here. Without these financial markets, there would be no growth and no job creation."
If you had to personify the bond market, to distill it into a single human being, it would be Rick Santelli. Short, pugnacious and instantly recognisable to anyone with a passing interest in finance in the US, the former derivatives trader reports on the market from the floor of the CME for the business television channel CNBC.
He also happens to be the man who sparked the Tea Party movement, or at least gave the inchoate uprising of anti-government, anti-bailout right-wingery its central historical metaphor. Enraged by an Obama administration plan to use a sliver of the Wall Street bailout fund to help struggling borrowers refinance their mortgages and avoid foreclosure, he launched an on-air tirade in February last year that went viral.
Let's launch a poll, he said, "to see if we really want to subsidise the losers' mortgages". With traders cheering behind him, he said that instead the homes should be foreclosed upon. "Give them to people that might have a chance to actually prosper down the road, and reward people that could carry the water instead of drink the water. This is America. How many of you people want to pay for your neighbour's mortgage, that has an extra bathroom and they can't pay their bills?" Again, the traders roared to support his point. "President Obama, are you listening? We're thinking of having a Chicago tea party in July. All you capitalists that want to show up to Lake Michigan, I'm going to start organising."
Santelli has kept the temperature up at roasting ever since. He gives voice to the market fundamentalist view that the bailouts were a dangerous perversion that served only to delay a reckoning. Governments around the world crafted their rescues of the financial sector and their separate stimulus plans so as to prevent an intolerable toll on people's jobs, savings and the economy as a whole. They learned the lessons of the Great Depression, channelled the wisdom of John Maynard Keynes, and stepped in to prevent economic demand from spiralling downward. They became spenders of last resort.
The effect, obviously, is to have pitched the amount of government debt across the West to levels never seen outside of wartime, and not in the modern era of ultra-mobile financial markets, where money can flood in and flee from a country at dangerous speeds.
"You can't hide from debt," Santelli explained when I accosted him on the floor. "We have just been adding to it. This is the last stop on the Adios Express line. The only deeper pocket I know of is God's – and I'm not sure he is going to help us out." He smiled his wide television smile, the one just on that line between charming and sinister.
"Europe governments are in a state of denial. The financial markets are merely the messenger. Don't look at this as 'us versus them'. When there were the riots in Greece I saw one of the chants was: 'The capitalists have taken our money.' Well, no. Capitalists created the structures which have funded their social programmes, up until the point that it all ran out of money."
Government debt in the West has not been so large, relative to countries' economies, since the aftermath of the Second World War, and there is no disputing the need to get it down. The debate is over how, and how quickly. The most obvious way is through big spending cuts, imposed early. But a few extra percentage points of economic growth could do more to reduce deficits than swinging the axe, so there is a counter argument that keeping government stimulus in the economy for longer will prove more effective. This is the argument for which the UK squabble over (a financially insignificant) £6bn in post-election cuts was a proxy.
The right way to have the argument is between thoughtful economists and policymakers. You won't get the absolutist tone used by some of the players in the Chicago pits, and their analogues that pop up in the television studios of Europe.
The numbers are the numbers, you might hear – as if the numbers were something fixed. Actually, the numbers are just the outcome of a million assumptions plugged into a trading firm's economic mode, and how the traders act on the numbers involves lashings of emotion too.
If there's one lesson that we have learned from the market gyrations of the past few years – whether it be the slow-motion boom and sudden bust of the Noughties housing and credit bubble, or the "flash crash" of the US stock market that lopped 1,000 points off the Dow Jones in the space of 20 minutes last month (only to put most of them back on again before the end of the day). It is that markets are prone to swing too far in each direction and generate their own self- reinforcing feedback loops. Some of the traders at the CME know this, too. They know why it happens, and they fear it is happening too often. For all the bustle of its pits, the CME has greatly expanded what used to be a side line: the electronic trading of derivatives. Now, 75 per cent of this much-increased volume of activity bypasses the floor entirely. As well as providing new ways for investors and speculators to do business, it has opened up the market to even more hedge funds and others who use computer programmes to try to predict the markets. As often as not, these programmes exacerbate moves in one direction, and make it harder for other traders to resist any gathering momentum. As Ron Pankau puts it, "Many times during the day, the market doesn't make any sense."
Add into this brew the invention in recent years of even more derivative products – credit default swaps – so new that they have not yet started to be traded on an exchange and instead exist only between banks. Here is another way for speculators to increase the size and speed of their bets on government debt. We are in a dangerous world when the price of a CDS is being quoted on the news as if it is the official share price of a government. When Greece's financial woes became evident, speculators rushed to place CDS bets on Italy, Portugal and other eurozone countries, encouraging a climate of fear, spurring governments to bigger budget cuts and ultimately triggering the "shock and awe" announcement of a $1 trillion European Union bailout fund. The numbers that will genuinely count are the numbers for economic growth, for tax revenues and government deficits, and for the interest rate at which real buyers of real government bonds are willing to invest when new government debt is issued – real buyers who are investing for the long term, not for days or minutes.
So far, on all these measures, the world economy has performed consistently more strongly, and (with only a handful of exceptions) government bond auctions have seen consistently more demand, than the militants of Chicago have predicted. The power of the vigilantes has grown, no question, but not as much as might be imagined. The bond market rampant can burn down houses, and we must be wary, but there is no need to surrender pre-emptively to this modern form of mob rule.
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