The perfect storm

The other day as I watched again the movie ”The Perfect Storm”, I could not stop thinking about the convergence of factors that triggered the inflationary pressure we are seeing today. The extremely loose monetary policy that has been in place since the financial crisis was given a boost during Covid, while at the same time supply chains were heavily disrupted. As the effects of the pandemic lessened, high disposable income and repressed demand meant products could not get to the shelves quickly enough.

If you have a product and many people want to buy it, you increase prices. People talk about demand side or supply side inflation. What we have here is inflation on both ends. Add to those staff shortages and wage growth in a very low employment scenario, and the Ukraine conflict disrupting supplies even more – and there you have a perfect storm.

To be honest, I walk around places like New York and, as I see a lot of closed businesses, I try to make sense of the unemployment situation. If a lot of small businesses have shut down, which means people are in the job market, you would expect unemployment to be higher. The pressure seems to be on blue-collar workers, while some of the bell weathers in technology are laying off staff. So for once, the common folk can haggle for better pay.

I feel like we are all on that fishing boat with a broken ice machine. Should we face the storm, or go around it? If we go around it, we risk the fish; if we go through it, we risk dying. The decision is with the captain. Well, the two captains, the government and the central bank. They will give the direction – or otherwise, as the GBP/USD going to parity and the Bank of England’s intervention on long-dated gilts seems to infer.

So what does it look like to go through the storm, or go around it?

I would say that going around it would be considering this inflation as a temporary phenomenon and letting high prices tamper with demand. But history has shown that usually this does not work too well, and if the inflation genie is out of the bottle, it is difficult to put it back in. Most of us do not remember this but fed funds went up to 20% in the ‘80s – and that did the job of killing inflation. If my memory does not fail me, the oil shock in the ‘70s together with exceptional growth triggered an inflationary trend that was only controlled by high rates that depressed demand. But the trigger for inflation then was not this perfect alignment of excess money supply and supply chain disruptions. Plus an oil shock.

Going through the storm is hiking rates to curb demand. While savers in Germany might like that, a lot of the voters don’t save much, they live day by day, and politicians will get their heads spinning to find ways around the demand squeeze that the central banks need to do. The UK volatility will probably follow in other places when the shock really starts to bite. We are seeing Europe taking energy companies back under the government umbrella, trying to rein in the increase in energy prices that will hurt when the winter comes, and that situation is not likely to get better any time soon.

What to expect next? I think the UK situation will happen in other countries – elsewhere leaders will try to counter the stance of the central bank by lowering taxes and keeping people happy and spending, which will not help with inflation and make the central bank tighten even more. In a country like the UK where mortgages are floating, this is not a great thing.

The British pound and other normally strong currencies are getting disproportionately weaker vs emerging markets. GBP/BRL is an interesting currency pair to see that. If the USD bid continues, that will make inflation an even bigger problem as a lot in the commodity space is USD priced.

I’m hearing that mortgage lenders are pulling out of the market in the UK. The volatility on long-dated rates and the failure of some of the fixed income deals, mean that treasurers are not having a good time. I am not surprised. For some time, we have been talking about asset liability management on the banking book, how important that is, and how being able to do interest rate swaps is key for the management of rate moves in a rising rate environment. A lot of banks still do not use derivatives given the infrastructure costs.

Doing an interest rate swap, pairing that with the bond or the loan, and moving that pair to an accrual account, requires you to be able to do the interest rate swap, that now needs to be cleared, or to have an initial margin, which will have collateral movements, usually daily. You need to do the hedge accounting relationship and the effectiveness testing on the books. Commercial bankers do not like volatility, and hedge accounting is a must if you want to get out on the other side of the storm. But after years of decreases in margins and competition from disruptors, banks are short of investment dollars. Doing these things using good old spreadsheets is just too manually intensive and requires a lot of know-how.

Small and medium-sized banks need to have a Treasury system, and they need something affordable. They need “Treasury as a Service”. Front-to-back robust processing of bonds and basic derivatives and using apps to augment the offering. At Finastra we have been obsessed with keeping things simple, getting clients live on treasury in weeks on the cloud and adding risk measures and collateral functionality in days using FusionFabric.cloud, our app store. We have over 200 apps live, and we have all our data sets and APIs published for anyone to see. We are striving to bring this functionality to more banks at pace, and to use local and global partners to create an ecosystem where banks do not capsize. We must accelerate.

I don’t see any other alternative. For Finastra to be relevant it needs to help financial institutions. And the only way to do that is to be open, to be an orchestrator to bring banks what they need quickly. Even if it is not our product.