In January 2022, when yields on US ten-year Treasury bonds were still roughly 1% and those on German Bunds were -0.5%, I warned that inflation would be bad for both stocks and bonds. Higher inflation would lead to higher bond yields, which in turn would hurt stocks as the discount factor for dividends rose. But, at the same time, higher yields on “safe” bonds would imply a fall in their price, too, owing to the inverse relationship between yields and bond prices.
This basic principle – known as “duration risk” – seems to have been lost on many bankers, fixed-income investors, and bank regulators. As rising inflation in 2022 led to higher bond yields, ten-year Treasuries lost more value (-20%) than the S&P 500 (-15%), and anyone with long-duration fixed-income assets denominated in dollars or euros was left holding the bag. The consequences for these investors have been severe. By the end of 2022, US banks’ unrealised losses on securities had reached $620 billion, about 28% of their total capital ($2.2 trillion).
Making matters worse, higher interest rates have reduced the market value of banks’ other assets as well. If you make a ten-year bank loan when long-term interest rates are 1%, and those rates then rise to 3.5%, the true value of that loan (what someone else in the market would pay you for it) will fall. Accounting for this implies that US banks’ unrealised losses actually amount to $1.75 trillion, or 80% of their capital.
The “unrealised” nature of these losses is merely an artifact of the current regulatory regime, which allows banks to value securities and loans at their face value rather than at their true market value. In fact, judging by the quality of their capital, most US banks are technically near insolvency, and hundreds are already fully insolvent.
To be sure, rising inflation reduces the true value of banks’ liabilities (deposits) by increasing their “deposit franchise,” an asset that is not on their balance sheet. Since banks still pay near 0% on most of their deposits, even though overnight rates have risen to 4% or more, this asset’s value rises when interest rates are higher. Indeed, some estimates suggest that rising interest rates have increased US banks’ total deposit-franchise value by about $1.75 trillion.
But this asset exists only if deposits remain with banks as rates rise, and we now know from Silicon Valley Bank and the experience of other US regional banks that such stickiness is far from assured. If depositors flee, the deposit franchise evaporates, and the unrealised losses on securities become realised as banks sell them to meet withdrawal demands. Bankruptcy then becomes unavoidable.
Moreover, the “deposit-franchise” argument assumes that most depositors are dumb and will keep their money in accounts bearing near 0% interest when they could be earning 4% or more in totally safe money-market funds that invest in short-term Treasuries. But, again, we now know that depositors are not so complacent. The current, apparently persistent flight of uninsured – and even insured – deposits is probably being driven as much by depositors’ pursuit of higher returns as by their concerns about the safety of their deposits.
In short, after being a non-factor for the last 15 years – ever since policy and short-term interest rates fell to near-zero following the 2008 global financial crisis – the interest-rate sensitivity of deposits has returned to the fore. Banks assumed a highly foreseeable duration risk because they wanted to fatten their net-interest margins. They seized on the fact that while capital charges on government-bond and mortgage-backed securities were zero, the losses on such assets did not have to be marked to market. To add insult to injury, regulators did not even subject banks to stress tests to see how they would fare in a scenario of sharply rising interest rates.
Now that this house of cards is collapsing, the credit crunch caused by today’s banking stress will create a harder landing for the real economy, owing to the key role that regional banks play in financing small and medium-size enterprises and households. Central banks therefore face not just a dilemma but a trilemma. Owing to recent negative aggregate supply shocks – such as the pandemic and the war in Ukraine – achieving price stability through interest-rate hikes was bound to raise the risk of a hard landing (a recession and higher unemployment). But, as I have been arguing for over a year, this vexing tradeoff also features the additional risk of severe financial instability.
Borrowers are facing rising rates – and thus much higher capital costs – on new borrowing and on existing liabilities that have matured and need to be rolled over. But the increase in long-term rates is also leading to massive losses for creditors holding long-duration assets. As a result, the economy is falling into a “debt trap,” with high public deficits and debt causing “fiscal dominance” over monetary policy, and high private debts causing “financial dominance” over monetary and regulatory authorities.
As I have long warned, central banks confronting this trilemma will likely wimp out (by curtailing monetary-policy normalisation) to avoid a self-reinforcing economic and financial meltdown, and the stage will be set for a de-anchoring of inflation expectations over time. Central banks must not delude themselves into thinking they can still achieve both price and financial stability through some kind of separation principle (raising rates to fight inflation while also using liquidity support to maintain financial stability). In a debt trap, higher policy rates will fuel systemic debt crises that liquidity support will be insufficient to resolve.
Central banks also must not assume that the coming credit crunch will kill inflation by reining in aggregate demand. After all, the negative aggregate supply shocks are persisting, and labour markets remain too tight. A severe recession is the only thing that can temper price and wage inflation, but it will make the debt crisis more severe, and that in turn will feed back into an even deeper economic downturn. Since liquidity support cannot prevent this systemic doom loop, everyone should be preparing for the coming stagflationary debt crisis.
Nouriel Roubini, Professor Emeritus of Economics at New York University’s Stern School of Business, is Chief Economist at Atlas Capital Team and the author of Megathreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them (Little, Brown and Company, 2022). Copyright: Project Syndicate, 2023, published here with permission.
70 Comments
Yes, great point :-). What it made me think about is - if it comes to pass (i.e., catastrophic financial collapse) - will it be to the benefit or the detriment of the planet's ecosystems and homeostasis? Assuming of course, there is no nuclear war accompanying the collapse.
We should acknowledge the possibility that the scenario he presented could come to pass. He's correct to point out the duration risk involved, which is a mathematical reality. His pessimistic outlook seems increasingly probable, as the situation appears to be gradually heading towards an unfavourable outcome. To prevent this, either the economy needs to slow down significantly, or inflation expectations need to rise. Unfortunately, neither scenario would be ideal. The former would negatively impact businesses and employees, while the latter would cause long-term rates to increase and could lead to a catastrophic drop in asset prices. It's safe to say that we should not expect a happy ending.
There's always a bitter old bloke down at the clubrooms drinking/smoking and forecasting doom and gloom - while holding forth on what needs to be done to save the world....... Every bowling club and cossie club has at least half a dozen of them hanging about - waiting for the next pension day.
TTP
by Retired-Poppy | 31st Mar 23, 10:12am
HouseMouse, if not Crickets then you're bound to get an argument that's void of insightful facts"
"After being a non-factor for the last 15 years... the interest-rate sensitivity of deposits has returned to the fore."
"Central banks also must not assume that the coming credit crunch will kill inflation by reining in aggregate demand. After all, the negative aggregate supply shocks are persisting, and labour markets remain too tight. A severe recession is the only thing that can temper price and wage inflation"
"Since liquidity support cannot prevent this systemic doom loop, everyone should be preparing.." And that is thankfully what the RBNZ has had the sense to do - Warn us. Whether we take notice of it or not is up to each of us, but the only thing that matters when making that choice is....can we survive being wrong?
This article which is linked above is also great:
https://www.project-syndicate.org/commentary/stagflationary-economic-fi…
If any of our resident ‘non-DGMs’ would like to present an argument as to why he is wrong, and we don’t have nasty economic times on our way, then I would be interested in hearing it.
A usual suspect will surely come along with the very rational explanation of ‘humans always fear the worse, reality is never as bad, DGMs have been predicting doom for years, a broken clock is right twice a day blah blah blah’
Failing that, an inane trolling comment.
I mean, everything fails and changes. The timeframes are up in the air.
But things also keep going. Predicting what happens is an exercise in folly, charts and whatnot aren't great representations of the day to day.
So it's more about a human need to try and preserve something indefinitely. Or think you can "call" when the game is up.
If you want something to be afraid of I can give you a long list.
We're due for a black swan motivated economic meltdown, that shouldn't be too much of a surprise.
How long it lasts and what rises from the ashes is something tricky to predict.
We know there's a high chance governments will try some sort of financial reinvention, and guys like Dr Doom won't be in the room when that occurs.
I can guarantee you he won't like whatever rescue they come up with.
A Black Swan is NOT required for the carnage to occur. Roubini is quite clear on that. The systemic issues and wicked problems apparent will result in carnage. Guaranteed.
Take stagflation. Inflation is proving very persistent. Too persistent. Even if interest rates are not increased too much further, they won’t be coming down in a hurry (bar a major black swan). This all but guarantees ongoing weak growth or recession, given mammoth debt levels (public and private). It also means that inflation is likely to be around for a while yet - as Roubini says, inflation will only be truly killed if a severe recession is induced by ongoing aggressive interest rate hikes. And that won’t/ can’t happen for a range of reasons.
So what is likely to happen is that moderately high inflation will persist, interest rates will be around current levels ( or a bit higher or lower) for at least the next 12 months, and we will have a pretty bad recession then very weak growth for a prolonged period.
Stagflation.
Its looking increasingly like the only way out is a globally coordinated debt jubilee. What are the chances of those who are owed, willingly swallowing the losses? The shear scale of these debt mountains might in some instances usher in outbursts of conflict. If goods cannot cross borders then this increases the chances troops will.
Nouriel Roubini does the hard yards on research and presents his findings in a well informed basic fashion. Years of can kicking has made the worse case scenarios even more plausible with limited places to hide. Going forward it looks like those who lose least wealth will emerge the best dressed.
The happy scenario you want to imagine is that inflation slowly but surely falls back to 2-3% in 2-3 years. But for that to happen, rates would have to remain at least as high as now, with flat to no new money/credit creation. Forget about the climate action as that requires cheap capital which you're not going to get. Asset prices will keep falling mildly for years. Also, you don't want too much change in the guard, Labour+Orr. Just be careful what you wish for. Happy endings usually don't occur, often something breaks because someone pulls the rug.
I think you miss the point that most banks are actually broke, meaning the real value of their assets is far less than their liabilities. This doesn't matter (like since the GFC), until it matters, (when people want their money back). SVB, Credit Suisse are prime examples.
I know I was just giving an antithesis to Nouriels piece. I don't think we will have a soft landing that some are hoping for. If the policymakers are successful in creating an illusion of a soft landing, I'm not buying it, it has to end badly and we're seeing that unfold
He is not wrong that central banks are marching us all into a doom loop. That's the inevitable consequence of the 'hike rates until something breaks' approach. In the US, the 'something' that breaks first is the financial system, in NZ it is the housing market, quickly followed by jobs and livelihoods. I won't bore everyone (again) with my views on whether hiking interest rates has any place in a 21st century approach to maintaining price stability.
Where Roubini is always wrong is in his misguided lumping together of public and private sector debt. Public sector 'debts' are private sector assets - you can't add them together and call that 'total debt'! Also, higher interest on public sector debt creates an increased flow of money from Government to the private sector. If Governments let this interest expenditure increase without increasing revenue (taxation) then higher interest rate payments create additional fiscal stimulus. In NZ, the Govt is currently throwing $6.5 million per day at the banks (4.75% interest on $48.5 billion of settlement account balances). It is poorly targeted stimulus, granted, but it is stimulus nonetheless.
Ultimately, it will be Govt's unlimited ability to spend (increase public debt) that will prevent us getting stuck in Roubini's doom loop.Let's hope that we learn from the experience and introduce the changes needed to create a simpler and more stable financial system.
I understand your nuanced perspective, but I believe there is an important point you're overlooking. The private assets you mentioned are fixed-rate instruments, which means they are vulnerable to fluctuations in interest rates. As demonstrated by the example of SVB, these assets can suffer losses when rates change. Although central banks have some power over short-term rates, they have no influence over long-term rates. Thus, it is our collective confidence in the stability of these institutions that sustains the system. While I am not predicting an imminent collapse, I acknowledge that if our expectations falter and long-term rates rise, it could lead to significant damage, as Nouriel has implied.
Yes, you're absolutely right that hiking interest rates reduces the value of Govt debt securities (private sector assets!) Some of those securities will be worth half what investors paid for them. US banks are allowed of course to continue to value debt securities on their balance sheets at the original price - but if they have to liquidate them and sell them at real market value (as SVB did) those losses become very real.
The Fed is currently accepting securities at original value as collateral for cash loans - and offering lines of credit globally. They will do whatever it takes to keep the banking system running - and they have unlimited liquidity to achieve it (hence, my doubt that we will enter the doom loop).
Where I think we differ is on the long-term rates point. The central banks can take absolute control of the yield curve - meaning that they can, at any time, bring down long-term rates and take the stress out of the financial system. The price they pay for that is lower borrowing costs in the economy, which they (mistakenly) think will lead to runaway inflation.
Controlling real yields is beyond their control. For example, if they set a limit on the yield, that limit will be denominated in the currency of that instrument. In a world where capital can move freely, if investors believe that the Fed has lost its credibility, the currency will devalue in order to increase the real yield. Ultimately, the stability of the financial system relies on people's trust in it. I'm not making any predictions, and I don’t believe it will be a single event, given the scale of it, it will be a multi year process. Unfortunately, New Zealand, being a small player, may have to accept whatever comes our way.
I think the currency devaluation point can get overplayed - the real world has friction, inertia, bounce backs, central bank interventions (e.g. BoJ back end of 2022 for example). But, completely agree with your point on the financial system and trust - I think we could even end up with 100% deposit insurance in the US, which would be a total game changer. I would thoroughly recommend Nathan Tankus's latest piece on this if you haven't already seen it - his pieces on SVB were excellent too.
Normally these things play out via a quick move of assets / cash to quality. US and to a degree European/German short dated gouvernment bonds become the instruments of choice. Yields can turn negitive if people think they have a real chance of loosing if they hold less secure stock.
Organised debt writeoff, forget it, first to T Bills or gold wins, there is no way anyone will agree to any loss.
Some might recall me mentioning a few weeks back that I got an email of a developer slashing the price of 2 bed townhouses in Glen Eden from $825k to $760k. Well they have slashed them again to $640k. I doubt they will be even breaking even at that price.
The carnage is well underway, folks.
And don’t say you weren’t warned.
Yup, and first four days this week of auction results in the Manukau area I have been monitoring for sometime:
1 property sold above RV - $25k (2%) up
18 properties sold below RV - average $214k (15%) down
range of those down was from $50k (6%) down to $710k (25%) down
Because of cheap credit we have seen assets price’s skyrocket in New Zealand this can be seen in housing market prices have grown around x 4 over last 15 years, with rates still under inflation the system is still screwed, the latest crash of around 20% will seem insufficient when the shit really hits the fan and system break’s
Perfect timing to borrow and splurge $30B ($90B by the time its finished) for a new road tunnel.
I would love to see how well we are positioned to fund that - start with the total central and local government debt numbers, and our required spend over the next few years to pay interest on that, dont forget the ever increasing superannuations and benefits (in a downturn).. potentially lower tax take (downturn plus more retirees and fewer workers) of course this before we even consider the staggering increase in water and healthcare costs.... rebuild costs to avoid climate damage to houses and infrastructure ongoing, our commitment to climate change - oh and did i forget education needs a massive investment (50% truancy and the rest with below oecd average skills) and i suspect we will suddenly want a few extra $billion for defence (world seems a bit scarier) and crime (downturns tend not to bring out the best in those who cant afford to feed their families...).
Prediction: Pre election both parties will sing big about what they will spend on and do. My mid 2024 that will all be in the bin and whoever wins will be cutting every possible project and staff... and austerity will be order of the day
"This basic principle – known as “duration risk” – seems to have been lost on many bankers, fixed-income investors, and bank regulators. "
I could see this coming and moved my retirement savings out of a conservative (mostly bond) investment fund in early Feb 22 with a 3 % loss over the previous 2 months. Put it into cash and then mostly into TD's as rates rose. The fund has since lost a further 10 %. The question is how much further will this unwind go.
Last week the local council published an indication of a 9.5 % rates increase. Half of that allocated to increased interest payments on loans. Today they announce it won't rise that much, they will just borrow more to cover the shortfall. Debt as lower cost option presumably.
Going shorter duration was a good call. Just to beware, depending on the maturity of your TD's and the duration exposure of your conservative fund you might effectively be increasing your duration exposure. i.e. the only difference between a 5 year bond and a 5 year TD is one is marked to market and the other is illiquid and valued only as a hold to maturity, the economic (realised or unrealised) losses from interest rates rising and falling are the same.
I have a dozen TD's put on 6 - 12 months, not all at once, spread across 4 banks. All mature between Jan. and Dec. this year. I told my wife mid 2021 that with over valued equities, low interest rates and rising looming inflation it was going to be hard for an investor to make real gains for maybe the next 5 years. Our strategy is to minimise risk and losses as much as possible. In saying that still uncomfortable with TD's due to OBR concerns and the inflation loss is significant.
If I understand this correctly it sounds like central banks are attempting to conduct a balancing act between capital losses and labour market stability due to high inflation. Crash the economy with high unemployment or allow an ongoing ‘haircut’ for investors as the ‘true’ value of investments are realised. The old capital versus labour conundrum. Interesting he calls them ‘wimps’ for taking this path. What would he prefer?
JavaBoy, those US banks invested money into treasuries at 2%, now at 4% they sitting on losses... In NZ banks put there money into residential mortgages and commercial lending, spare cash is help in esas at OCR rate... sure they have some Corp bonds and Gov debt on books but that should be interest rate hedged. So NZ banks do not have this risk, of sitting on a big pile of non marked to market assets.
NZ Banks keep mortgages on balance sheet ....
The risk of doing so is that they own the credit risk if there are a lot of defaults. So far thats not so high, IMHO it's going to increase. If this occurs and the losses got high enough the banks would have to raise more capital.
By this point even HW2 will have given up Spruiking, paradoxically, it will probably be close to the bottom..... and will actually finally be perhaps time to buy.
The RBNZ cannot let any of the major banks ever fail, they can print if they have to, The NZD would suffer the consequences.
the indicator of all this is the banks share price, keep them on a watchlist if you are worried.
Probably right.
But before any defaulting of mortgages goes on, those with an income ( a job) and that can't meet the new weekly debt repayment will be 'offered' a chance to extend their duration. Anyone,say, who just took out a 30-year mortgage that runs into trouble with payments will be offered a 40-year term or 50 to 'ease' the weekly payment and keep the loan regular. If or when % rates fall, they can adjust the term as necessary.
If NZ banks are properly managed, they should have minimal duration risk. They tend to hedge fixed rate assets with fixed rate deposits, bonds or swap them to floating rate. Amazing that this is not at least always the case in the US - that even sizable banks could be so mismanaged.
What's amazing is Roubini has made a whole career out of this, in the same way that his targets have made whole careers out of being air-suspended Wile E .Coyotes. What will the Debtsters and Roubini do for a job when the collapse has happened and there's nothing left to predict.
It's not amazing at all.
We probably peaked about the time he started 'working' (it isn't work in the physics sense, but never mind). While there have been impressive efforts to paper over the decline, and a lot of goal-post shifting (just look at how so many countries added spurious stuff to their GDP's), the trend has been increasingly clear - and it ain't GROWTH.
So he - and the likes of Steve Keen and Timothy Parrique - were always going to be righter, oftener.
https://www.youtube.com/watch?v=Nw_cdqQHGA8&ab_channel=FluffyPlaysandVl…
It's not all doom and gloom.... well it is, but its working out great for me :D
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