Anytime the Fed raises interest rates aggressively, it provokes a Black Swan event like the Tequila and the Asian crises in the 1990s and the Lehman Collapse in 2008. They all took Wall Street another leg down.
James E Demmert, the Managing Partner of Main Street Research, sees the possibility of Wall Street heading in this direction. "Central banks usually raise interest rates until they 'break something,' I would suggest this time is possibly a more difficult period," he told International Business Times in an email. "That's because almost all central banks across the globe are in a rate hiking cycle - given inflation rates."
Demmert points to the U.K. markets, which came close to the breaking point from rising interest rates last month. They forced the Bank of England to step back into the credit markets to add liquidity. "This should be a warning to all investors that the combination of rising rates and the central banks' purposeful mission to contract economies is a danger for financial markets," he added.
If one of the world's central banks ends up "breaking things," Demmert expects global equity prices to take another leg down somewhere between another 10-20%. It would bring the total bear market declines in the 35-45% range, typical for recessionary bear markets.
What would central banks break this time around that could cause a Black Swan event? How bad would it be? It's hard to say.
Black swans are low probability high events that are hard to predict, as can show up in different segments of the global financial markets. Thus, generating the correct probability distribution and calculating the expected value of losses is hard.
But that hasn't stopped experts from trying to identify some areas of financial markets prime for a Black Swan event. For instance, Darin Tuttle, CFA Founder & CIO at Tuttle Ventures, looks into the debt market, where rising interest rates and deteriorating credit quality could cause defaults.
But he thinks the subsequent major default will be Sovereign, not Corporate. "We believe the next major default will be sovereign, not corporate, based on the deteriorating credit quality of countries holding foreign debt, political posturing, and elevated geopolitical risks," he told IBT. "Deteriorating credit quality Sovereign defaults occur alongside recessions, banking crises, currency crises, and other severe shocks."
Matthew Grishman, Principal & Wealth Advisor Gebhardt Group, Inc., thinks that financial markets are already in a Black Swan event caused by the Covid pandemic. "The pandemic caused the Fed to take drastic monetary easing policy," said IBT in an email. "It also caused our federal government, through the executive and legislative branches of government, to take drastic fiscal easing policies (financial stimulus)."
Grishman further argues that Black swan events generally occur when no one expects or looks for them. While he sees the possibility of the Fed's tightening causing a super-rare market or economic circumstance, he says that we won't know it happened until after the fact. "You can be prepared in advance," he adds. "I like to call this planning "lifeboat drills," and we do this religiously with our private clients."
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