Fears of a recession in the US. The biggest one-day fall on the Japanese stock market since 1987. Policymakers away on their summer breaks, leaving their deputies in charge. All familiar enough territory for August – one of the most dangerous months in the economic and financial calendar.
In theory, August should be a month when not much happens and often that is the case. Stock market trading volumes tend to be light and if August starts calm it will tend to stay calm. But bad things can happen and when they do they can have profound consequences.
Henry Allen, macro strategist at Deutsche Bank, says the late-summer period is often a difficult time for markets. He notes the average spike in the VIX index (which measures financial market volatility and is commonly known as Wall Street’s Fear Index) has been higher in the July to September period than any other quarter.
So the markets are right to tread carefully in August. In some years it is the month when a crisis erupts, in others it is when strains become apparent that eventually lead to crises in September – if anything a month with an even worse reputation for trouble.
At the end of July 1990, few were expecting Saddam Hussein’s Iraq to invade Kuwait the following month. But on 2 August, Iraq’s troops crossed the border, triggering a threefold increase in oil prices. This added to already strong cost of living pressures in the west, including Britain, where the annual inflation rate climbed above 10%. Kuwait was swiftly liberated by a US-led international coalition but at a cost. As is often the case, a higher oil price meant recession in the developed west.
When the first Gulf war started in 1990, the Soviet Union was on its last legs but by the time of the next August crisis communism had collapsed. A deep slump was followed in the early 1990s by heavy foreign borrowing to finance economic recovery and by the summer of 1998 the government of president Boris Yeltsin was struggling to pay its debts. By August, after more than a year resisting the pressure to devalue the rouble, Yeltsin capitulated. Russia, as the Soviet Union was now known, devalued and defaulted on its overseas debt. Investors who had bet against a default lost heavily, with the most significant casualty a US hedge fund – Long Term Capital Management – which collapsed and had to be bailed out by a consortium of 14 banks in a deal organised by the US Federal Reserve.
Fears of a market meltdown proved unfounded on this occasion but instead provided a warning of what was to come less than a decade later in August 2007. Few realised it at the time but the decision by the French bank BNP Paribas to close three of its hedge funds because of losses on sub-prime US mortgages would have momentous consequences.
Banks, including all the world’s biggest, had taken enormous punts on the American housing market, punts that started to go sour as US interest rates were ratcheted up. To make matters worse, the widespread use of complex financial instruments – known as derivatives – meant it was unclear how big the losses were and how heavily individual banks were exposed.
Given the uncertainty, banks stopped lending to each other and credit flows dried up. The following month customers queued outside branches of Northern Rock as the UK suffered the first run on a high street bank in almost 150 years.
August 2008 was the lull before the storm. Early in the month, the Bank of England debated whether to raise interest rates in response to rising inflation. But the cracks in the global financial system were becoming ever wider. On 15 September Lehman Brothers went bankrupt after no buyer could be found for the US investment bank.
With investors in the dark about which bank might be next to fall, panic set in. Fears that the wholesale collapse of the banking system might lead to a second Great Depression prompted emergency action from governments around the world. Banks were either bailed out or nationalised, interest rates were slashed, and central banks responded to a dearth of private credit by creating new electronic money through the process known as quantitative easing. A return to the 1930s was avoided – but only just.
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The UK has a special reason for being anxious in August. There have been four devaluations of the pound in the past 100 years – 1931, 1949, 1967 and 1992 – and three of them have taken place in September. In every case the writing was on the wall in August.
In 1992, for example, John Major’s government spent the month struggling to maintain the pound in the exchange rate mechanism (ERM), a system under which European countries had to peg their currencies to the German mark even if it meant raising interest rates in a recession. George Soros and other currency speculators spent the month building up positions in anticipation that the UK would eventually leave the ERM, which it did on 16 September 1992, known as Black Wednesday.
Not every late summer is as dramatic as 1990, 1992, 2007 or 2008, but the frequency with which crises have occurred meant this week’s mini crash set alarm bells clanging.
As Holger Schmieding, chief economist at Berenberg bank, said: “It is almost a pattern. Not for the first time, equity markets have fallen sharply just before the end of my summer holidays.”