In January 2022, when the yield on the US 10-year Treasury bond was still around 1% and the German Bund at -0.5%, I warned that inflation would be bad for both stocks and bonds. Higher inflation will lead to higher bond yields, which in turn will hurt stocks by increasing the discount factor for dividends. But a higher yield on ‘safe’ bonds would also mean a fall in their price due 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. Rising inflation led to higher bond yields in 2022, 10-year Treasuries losing more value (-20%) than the S&P 500 (-15%), and long-term fixed-income assets denominated in dollars or euros Anyone holding the bag was released. The consequences for these investors have been dire. By the end of 2022, unrealized losses on the securities of US banks had reached $620 billion, which was about 28% of their total capital of $2.2 trillion.
Making matters worse, high interest rates have also eroded the market value of banks’ other assets. If you take out a 10-year bank loan when long-term interest rates are 1%, and those rates go up to 3.5%, the value of that loan will drop. Accounting for this means that US banks’ unrealized losses are actually $1.75 trillion, or 80% of their capital. The unrealized nature of these losses is simply an artifact of the regulatory regime, which allows banks to value securities and loans at their face value rather than at market value. Given the quality of their capital, most US banks are technically close to bankruptcy and hundreds are completely insolvent.
To be sure, rising inflation reduces the true value of bank liabilities (deposits), thereby increasing their ‘deposit franchise’, an asset that is not held on their balance sheet. Since banks still pay nearly 0% on most of their deposits, even when overnight rates jump to 4% or more, the value of this asset increases when interest rates are high. Indeed, some estimates suggest that rising rates have increased the total deposit-franchise value of American banks by about $1.75 trillion. But this asset only exists when deposits remain with banks as rates rise, and we now know from Silicon Valley Bank and other US regional banks that such stability is far from assured. If depositors flee, the deposit franchise evaporates, and unrealized losses on the securities must be realized as banks sell them to meet withdrawal demands. Bankruptcy then becomes inevitable.
Furthermore, the deposit-franchise argument assumes that most depositors are dumb and will keep their money in 0% interest accounts when they can earn 4% or more in safe money-market funds that invest in short-term Treasuries. . But, again, we see that depositors are not so complacent. The continued flight of deposits is probably being driven by the search for higher returns by depositors because of their concerns about the safety of their deposits.
In short, after being a non-factor for the past 15 years, the interest rate sensitivity of bank deposits has returned to prominence. Banks assumed a predictable duration risk as they sought to reduce their net-interest margin. They seized on the fact that capital charges on government bonds and mortgage-backed securities were zero, but losses on such assets were not to be marked to market. Regulators do not subject banks to stress tests to see how they would perform in a scenario of rapidly rising interest rates.
Now that this house of cards is collapsing, given the role of regional banks, the credit crunch caused by the banking stress will create a difficult situation for the real economy. Central banks not only face a dilemma, they also face a dilemma. Due to recent negative aggregate supply shocks, achieving price stability through interest rate increases was bound to increase the risk of a hard landing (recession and high unemployment). But this trade-off also includes the risk of serious financial instability.
Borrowers are facing rising rates on fresh borrowings and existing liabilities that have matured and need to be rolled over. But the rise in long-term rates is causing huge losses to creditors holding long-term assets. As a result, the US economy is falling into a debt trap, with high public deficits and debt leading to fiscal dominance over monetary policy, and high private debt leading to fiscal dominance over monetary and regulatory authorities.
As I have long warned, avoiding a financial meltdown will erase the dilemma central banks are facing (by reducing monetary-policy normalization), and set the stage for lowering inflation expectations. Will go Central banks should not delude themselves into thinking they can still achieve both price and financial stability through some sort of separation principle (raising rates against inflation while using liquidity support for financial stability) . In a debt trap, higher policy rates would fuel a systemic debt crisis, which liquidity support would be insufficient to resolve.
Central banks also should not assume that the coming credit crunch will kill inflation by reining in demand. After all, supply shocks persist and labor markets remain very tight. A severe recession is the only thing that might lower prices and reduce inflation, but it would make the debt crisis worse, which could lead to a deeper recession. Since liquidity support cannot stop this systemic doom cycle, everyone should prepare for a stagnant inflationary debt crisis. ©2023/Project Syndicate
Nouriel Roubini is Professor Emeritus of Economics at New York University’s Stern School of Business and author of ‘Megathreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them’.
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