Early Warning Signals in a Fragile System
[ed note: here is Part 1; if you have missed it, best go there and start reading from the beginning]
We recently received the following charts via email with a query whether they should worry stock market investors. They show two short term interest rates, namely the 2-year t-note yield and 3 month t-bill discount rate. Evidently the moves in short term rates over the past ~18 – 24 months were quite large, even if their absolute levels remain historically low.
Sizable moves higher in short term interest rates were recorded over the past two years. 2 year note yields only started moving up in mid 2016, but the surge in t-bill discount rates has been in train since late 2015 already. The moves in short term rates come from extremely low levels, but they are nevertheless quite noteworthy – click to enlarge.
The first thing that comes to mind in connection with asset prices is that the cost of carry for leveraged positions is rising. Eventually this will have an effect on such positions, particularly in fixed-income instruments, which inter alia include structured products such as CLOs (collateralized loan obligations). Some market participants reportedly employ leverage of up to 1:10 in these in order to boost returns, which the banks are apparently happy to provide, as the risk is deemed to be low.
As we have discussed previously, CLOs are conceptually not different from the CMOs that created such heavy conniptions in 2007-2009, but CLOs ultimately turned out to be quite resilient at the time. The problem is of course that it is definitely not a given that they will be similarly resilient in the next crisis. Banks no longer have large proprietary books of corporate bonds, but by providing margin loans to investors who buy them on leverage, they remain exposed – and the degree of leverage is reminiscent of the margin requirements of Wall Street bucket-shops in the 1920s.
Obviously these enhanced returns are highly dependent on borrowing costs, so rising short term rates are bound to become a problem at some point. As a more general remark: the central bank policy of suppressing rates to zero or close to zero provided the incentive for investors to take up enormous leverage, which is seen as the only way of obtaining half-way decent yields. In other words, central bank manipulation of interest rates has definitely made the financial system a lot more fragile.
There is a feedback loop between the Federal Reserve’s interest rate policy and market rates, but market expectations are historically the main driver; it usually appears as though the Fed is simply following the lead of market rates. It should also be noted that market-based inflation expectations so far remain quite subdued. 5-year TIPS yields have oscillated between -10 to +30 basis points this year, after trading as high as 52 basis points in December 2015.
5 year TIPS yields are a good proxy for medium term …read more
Source:: Acting Man
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