ruin is coming

Image: Matheus Bertelli


A severe recession is the only thing that can moderate wage and price inflation, but it will make the debt crisis more severe.

Faced with persistently high inflation, recession risks and now a looming financial sector insolvency crisis, central banks like the US Federal Reserve are facing a trilemma. Unable to fight inflation and simultaneously provide liquidity support, the only remaining solution is a severe recession – and therefore a broader debt crisis.

In January 2022, when ten-year US Treasury yields were still around 1% and German central bank yields were -0,5%, I warned that inflation would be bad for both stocks and titles. Higher inflation would lead to higher bond yields, which would in turn hurt equities as the dividend discount factor increases. But at the same time, higher yields on “safe” bonds would also imply a fall in their price, due to the inverse relationship between yields and bond prices.

This basic tenet – known as “duration risk” – seems to have been lost on many bankers, fixed income investors and banking regulators. As rising inflation in 2022 led to higher bond yields, ten-year Treasuries lost more value (-20%) than the S&P 500 (-15%). Now, anyone with long-term fixed-income assets denominated in dollars or euros has been naked on a cold night. The consequences for these investors were severe. By the end of 2022, US banks' unrealized losses on securities reached $620 billion, about 28% of their total capital ($2,2 trillion).

To make matters worse, higher interest rates also reduced the market value of banks' other assets. If you take out a ten-year bank loan when long-term interest rates are 1%, and those rates rise to 3,5%, the true value of that loan (what someone else in the market would pay for it) will fall. Accounting for this implies that US banks' unrealized losses actually amount to $1,75 trillion, or roughly 80% of their capital.

The “unrealized” nature of these losses is just an artifact of the current regulatory regime, which allows banks to value bonds and loans at their face value rather than their true market value. Indeed, judging by the quality of their capital, most US banks are technically close to insolvency, and hundreds are in fact fully insolvent already.

Indeed, rising inflation reduces the true value of banks' liabilities (deposits), increasing their “deposit allowance,” an asset that is not on their balance sheet. As banks still pay close to 0% on most of their deposits, even though fees overnight have risen to 4% or more, the value of that asset increases when interest rates are higher. Indeed, some estimates suggest that rising interest rates have increased the total value of US banks' deposit franchise by about $1,75 trillion.

But that asset only exists if deposits stay with banks as rates rise. We now know, from the Silicon Valley Bank case and the experience of other US regional banks, that such stickiness is far from guaranteed. If depositors flee, the deposit franchise evaporates and unrealized losses on bonds become realized as banks sell them to meet withdrawal demands. Bankruptcy then becomes inevitable.

Furthermore, the “deposit allowance” argument assumes that most depositors will keep their money in accounts with interest close to 0%, when they could be earning 4% or more in fully insured money market funds that invest in Treasuries. short term. But then again, we now know that depositors are not so complacent. The current, seemingly persistent flight from uninsured – and even insured – deposits is likely being driven as much by depositors' quest for higher returns as by their concerns about the safety of their deposits.

In short, after not being a factor for the past 15 years – since politics and short-term interest rates dropped to near zero after the 2008 global financial crisis – the sensitivity of deposits to interest rates has returned to the fore. Banks took on a risk of highly predictable duration because they wanted to fatten their net interest margins. They took advantage of the fact that while capital charges on government bonds and mortgage-backed securities were nil, the losses on these assets were not valued by the market. To add insult to injury, regulators didn't 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 crisis caused by today's banking stress will create a harder landing for the real economy, due to the key role that regional banks play in financing small and medium-sized enterprises and families. Central banks therefore face not just a dilemma, but a trilemma. Due 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 increase the risk of a hard landing (a recession and higher unemployment). . But, as I've been arguing for over a year, this vexing switch also carries the added risk of severe financial instability.

Borrowers are facing rising rates – and therefore much higher costs of capital – on new loans and on existing liabilities that have come due and need to be rolled over. But rising long-term rates are also leading to massive losses for lenders holding long-term 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 debt causing “financial dominance” over monetary and regulatory authorities.

As I have been warning for a long time, central banks facing this trilemma are likely to disappear (reducing monetary policy normalization) to avoid a self-reinforcing economic and financial meltdown. Now, the scenario will be set for a loss of anchor in inflation expectations over time. Central banks should not delude themselves into thinking that they can still achieve financial and price stability through some sort of separation principle (raising rates to fight inflation while using liquidity support to maintain liquidity). financial stability). In a debt trap, higher policy-provided interest rates will fuel systemic debt crises that liquidity support will be insufficient to resolve.

Central banks also shouldn't assume that the next credit crunch will kill inflation by curbing aggregate demand. After all, negative aggregate supply shocks persist and labor markets remain very tight. A severe recession is the only thing that can moderate wage and price inflation, but it will make the debt crisis more severe, and that, in turn, will feed back into an even deeper economic recession. Since liquidity support cannot stop this cycle of systemic doom, everyone should be preparing for the next stagflationary debt crisis.

* Nouriel Roubini is professor of economics at the Stern School of Business at New York University. Author, among other books, of  MegaThreats: ten dangerous trends that imperil our future, and how to survive them (Little, Brown and Company).

Translation: Eleutério FS Prado.

Originally published on the portal Project syndicate.

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