Markets Vanish – “In a Flash”

Following is a short excerpt from “War of the Nerds,” which I wrote for the December, 2006, edition of the Gloom, Boom & Doom Report. I discussed the crises an investor (“Our Serious Investor”) navigated from the 1960s to the present. Doomsday had been predicted since the dollar crises of the 1960s, yet risk had been transient. By the fall of 2006, it was obvious the U.S. mortgage market and banking system were in collapse, but securities markets were deemed riskless, as measured by bond and credit-default spreads. It is timely to resurrect the vanishing bond markets of 1914 and 2007 after the failed or distressed auctions since December 27, 2010, of euro zone, Chinese, and U.S Treasury bonds with 5-year and 7-year maturities.

The historian Niall Ferguson (The Cash Nexus, War of the World) has written a paper on the risk imbedded in sovereign bond spreads between 1848 and 1914: “Political Risk and the International Bond Market Between the 1848 Revolution and the Outbreak of the First World War.” Published in the Economic History Review earlier this year, his exhaustive study of weekly great-power bond prices (United Kingdom, France, Germany, Austria-Hungary and Russia) comes to a surprising conclusion – the closer Europe edged towards war, the less the financial markets cared. Ferguson sees two distinct periods: from 1848 through 1880, the markets were anxious. Sovereign bonds were sold at the slightest scent of war. After 1880, the response to international tensions grew less and less pronounced.

….It is 2006. Our Serious Investor has grown calloused to once-in-the-history-of-the-universe events. Our Investor survived the dollar crises, the stock market collapse and deep recession of 1973-1974, the Business Week “Death of Equities” front cover, the $250 billion federal budget deficits of the 1980s, the frequent financial and derivative crises of the past twenty years (far more prevalent than between 1950 and 1970), the current $500 billion federal budget deficits, and the (prospective) $1 trillion trade deficit. Our Serious Investor has prospered. He gradually learned to shrug off the deteriorating macro world. He grew accustomed to the “Greenspan put” (that is, central banks will bail out any-and-all financial meltdowns), the risky adventures of hedge funds, the abandonment of debt covenants by bond issuers, the private-equity moon shot; he has, by now, grown so accustomed to the warnings that he keeps his head down, plugs away….

Ferguson’s narrative of the countdown to war is a splendid chronology of how quickly the world can change: “It was not until 22 July [1914] – more than three weeks [after Archduke Franz Ferdinand of Austria was assassinated, on June 28, 1914] – that the possibility of a European political crisis was first mentioned as a potential source of financial instability in the financial pages of The [London] Times….

The 2-1/2% British consols rose from a 3.30% yield on July 7 to 3.31% on July 22 – a single basis point of fear…. Tensions rose on the exchanges and grew acute on July 27 when the Vienna and Budapest exchanges closed. The Sarajevo incident could still be interpreted as a local affair, but trading slowed on the other European exchanges. Now [British] consols rose to 3.45%. The St. Petersburg exchange closed on July 29 and the Economist considered the “Berlin and Paris bourses closed in all but name.”

….A wholly unanticipated domino effect now engulfed London. The bond market did not seem to acknowledge this vaporization of liquidity: “….The Economist was especially struck by the widening of the bid-ask spread for consols (the gap between buyers’ offers and sellers’ asking prices) to a full percentage point, compared with a historic average of one-eighth of 1 per cent… ”

The London market started to close on July 29. London clearing banks concentrated on funding their stock-exchange clients, eight of which failed by the end of the day. On July 30, the Bank of England raised its discount rate from 3% to 5%. On July 31, the Stock Exchange was closed and the Bank of England raised its discount rate from 5% to 8%.

As to how much we can trust the Greenspan “put”: “[T]he British and Continental financial authorities pulled every trick.” [Ferguson] furnishes a list of clever, arbitrary and confiscatory maneuvers, but, “systematic central bank interventions to maintain bond prices” only worked for a time. Government assistance “could only disguise the crisis that had been unleashed in the bond market; it could not prevent it.” [My bold- FJS]

Ferguson scrapes up the debris: “For all save the holders of British consols, who could reasonably hope that their government would restore the value of their investments when the war was over, these outcomes [for French, German, Austrian, and Russian sovereign bond holders] were even worse than the most pessimistic pre-war commentators had foreseen. The fact that investors do not seem to have considered such a scenario until the last week of July 1914 surely tells us something important about the origins of the First World War. It seems as if, in the words of The Economist, the City only saw ‘the meaning of war’ on July 31-‘in a flash’.”

Aside from the origins of World War I, the last week of July 1914 surely tells us something important about investors today.

“The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened, is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.”

-George Eliot, Silas Marner

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