Will rapidly rising interest rates rip through the U.S. financial system like a giant lawnmower blade? Yes, the U.S. economy survived much higher interest rates in the past, but at that time there were not hundreds of trillions of dollars worth of interest rate derivatives hanging over our financial system like a Sword of Damocles. This is something that I have been talking about for quite some time, and now a Mexican billionaire has come forward with a similar warning. Hugo Salinas Price was the founder of the Elektra retail chain down in Mexico, and he is extremely concerned that rising interest rates could burst the derivatives bubble and cause “massive bankruptcies around the globe”. Of course there are a whole lot of people out there that would be quite glad to see the “too big to fail” banks go bankrupt, but the truth is that if they go down our entire economy will go down with them. Our situation is similar to a patient with a very advanced stage of cancer. You can try to kill the cancer with drugs, but you will almost certainly kill the patient at the same time. Well, that is essentially what our relationship with the big banks is like. Our entire economic system is based on credit, and just like we saw back in 2008, if the big banks start failing credit freezes up and suddenly nobody can get any money for anything. When the next great credit crunch comes, every important number in our economy will rapidly start getting much worse.
The big banks are going to play a starring role in the next financial crash just like they did in the last one. Only this next crash may be quite a bit worse. Just check out what billionaire Hugo Salinas Price told King World News recently…
I think we are going to see a series of bankruptcies. I think the rise in interest rates is the fatal sign which is going to ignite a derivatives crisis. This is going to bring down the derivatives system (and the financial system).
There are (over) one quadrillion dollars of derivatives and most of them are related to interest rates. The spiking of interest rates in the United States may set that off. What is going to happen in the world is eventually we are going to come to a moment where there is going to be massive bankruptcies around the globe.
What is going to be left after the dust settles is gold, and some people are going to have it and some people are not. Then the problem is going to be to hold on to what you’ve got because it’s not going to be a very pleasant world.
Right now, there are about 441 trillion dollars of interest rate derivatives sitting out there. If interest rates stay about where they are right now and they don’t go much higher, we will be fine. But if they start going much higher, all bets will be off and we could see financial carnage on a scale that we have never seen before.
And at the moment the big banks have got to behave themselves because the government is investigating allegations that they have been cheating pension funds and other investors out of millions of dollars by manipulating the trading of interest rate derivatives. The following is from an article that the Telegraph posted on Friday…
The Commodity Futures Trading Commission (CFTC) is probing 15 banks over allegations that they instructed brokers to carry out trades that would move ISDAfix, the leading benchmark rate for interest rate swaps.
Pension funds and companies who invest in interest rate derivatives often deal with banks to insure against big movements in the ISDAfix rate or to speculate on changes to interest rate swaps
ISDAfix is published each morning after banks submit bids for swaps via Icap, the inter-dealer broker, in a number of currencies. The CFTC has been investigating suggestions that the banks deliberately moved the rate in order to profit on these deals.
Given the hundreds of trillions of dollars worth of interest rate derivatives trades that occur annually, even the slightest manipulation can have a substantial effect. The CFTC, which started to investigate ISDAfix after last summer’s Libor scandal has now been handed emails and phone call recordings that show the rate was deliberately moved, according to Bloomberg.
Essentially they got their hands caught in the cookie jar and so they have got to play it straight (at least for now).
Meanwhile, it looks like the Fed may not be able to keep long-term interest rates down for much longer.
The Federal Reserve has been using quantitative easing to try to keep long-term interest rates low, but now some officials over at the Fed are becoming extremely alarmed about how bloated the Fed balance sheet has become. For example, the following was recently written by the head of the Dallas Fed, Richard Fisher…
This later program is referred to as quantitative easing, or QE, by the public and as large-scale asset purchases, or LSAPs, internally at the Fed. As a result of LSAPs conducted over three stages of QE, the Fed’s System Open Market Account now holds $2 trillion of Treasury securities and $1.3 trillion of agency and mortgage-backed securities (MBS). Since last fall, when we initiated the third stage of QE, we have regularly been purchasing $45 billion a month of Treasuries and $40 billion a month in MBS, meanwhile reinvesting the proceeds from the paydowns of our mortgage-based investments. The result is that our balance sheet has ballooned to more than $3.5 trillion. That’s $3.5 trillion, or $11,300 for every man, woman and child residing in the United States.
Fisher has compared the current Fed balance sheet to a “Gordian Knot”, and he hopes that the Fed will be able to unwind this knot without creating “market havoc”…
The point is: We own a significant slice of these critical markets. This is, indeed, something of a Gordian Knot.
Those of you familiar with the Gordian legend know there were two versions to it: One holds that Alexander the Great simply dispatched with the problem by slicing the intractable knot in half with his sword; the other posits that Alexander pulled the knot out of its pole pin, exposed the two ends of the cord and proceeded to untie it. According to the myth, the oracles then divined that he would go on to conquer the world.
There is no Alexander to simply slice the complex knot that we have created with our rounds of QE. Instead, when the right time comes, we must carefully remove the program’s pole pin and gingerly unwind it so as not to prompt market havoc. For starters though, we need to stop building upon the knot. For this reason, I have advocated that we socialize the idea of the inevitability of our dialing back and eventually ending our LSAPs. In June, I argued for the Chairman to signal this possibility at his last press conference and at last week’s meeting suggested that we should gird our loins to make our first move this fall. We shall see if that recommendation obtains with the majority of the Committee.
But of course it should be obvious to everyone that the Fed is not going to be able to reduce the size of its balance sheet without causing huge distress in the financial markets. A few weeks ago, just the suggestion that the Fed may eventually begin to slow down the pace of quantitative easing caused the markets to throw an epic temper tantrum.
Unfortunately, the Fed may not be able to keep control of long-term interest rates even if they continue quantitative easing indefinitely. Over the past several weeks long-term interest rates have been rising steadily, and the yield on 10 year U.S. Treasuries crept a bit higher on Monday.
At this point, many on Wall Street are convinced that the bull market for bonds is over and that rates will eventually go much, much higher than they are right now no matter what the Fed does. The following is an excerpt from a recent CNBC article…
The Federal Reserve will lose control of interest rates as the “great rotation” out of bonds into equities takes off in full force, according to one market watcher, who sees U.S. 10-year Treasury yields hitting 5-6 percent in the next 18-24 months.
“It is our opinion that interest rates have begun their assent, that the Fed will eventually lose control of interest rates. The yield curve will first steepen and then will shift, moving rates significantly higher,” said Mike Crofton, President and CEO, Philadelphia Trust Company told CNBC on Wednesday.
If the yield on 10 year U.S. Treasuries does hit 6 percent, we are going to have a major disaster on our hands.
Hugo Salinas Price is exactly right – the derivatives bubble is the number one threat that our financial system is facing, and it could potentially bring down a whole bunch of our big banks.
But for the moment, Wall Street is still in a euphoric mood. The Dow is near a record high and many investors are hoping that this rally will last for the rest of the year.
Unfortunately, I wouldn’t count on that happening. The truth is that the stock market has become completely divorced from economic reality.
Since March 2009, the size of the U.S. economy has grown by approximately $1.3 trillion, but stock market wealth has grown by an astounding $12 trillion.
And the stock market has just kept on rising even though GDP growth forecasts have been steadily falling.
It doesn’t make any sense.
But Obama, Bernanke and the wizards on Wall Street assure us that there is no end to the party in sight.
Believe them at your own peril.
The people at the controls are completely and totally clueless and we are rapidly careening toward disaster.
Perhaps we should do what one little town in Minnesota did and put a 4-year-old kid in charge.
That kid certainly could not be much worse than our current leadership, don’t you think?
There is one vitally important number that everyone needs to be watching right now, and it doesn’t have anything to do with unemployment, inflation or housing. If this number gets too high, it will collapse the entire U.S. financial system. The number that I am talking about is the yield on 10 year U.S. Treasuries. When that number goes up, long-term interest rates all across the financial system start increasing. When long-term interest rates rise, it becomes more expensive for the federal government to borrow money, it becomes more expensive for state and local governments to borrow money, existing bonds lose value and bond investors lose a lot of money, mortgage rates go up and monthly payments on new mortgages rise, and interest rates throughout the entire economy go up and this causes economic activity to slow down. On top of everything else, there are more than 440 trillion dollars worth of interest rate derivatives sitting out there, and rapidly rising interest rates could cause that gigantic time bomb to go off and implode our entire financial system. We are living in the midst of the greatest debt bubble in the history of the world, and the only way that the game can continue is for interest rates to stay super low. Unfortunately, the yield on 10 year U.S. Treasuries has started to rise, and many experts are projecting that it is going to continue to rise.
On August 2nd of last year, the yield on 10 year U.S. Treasuries was just 1.48%, and our entire debt-based economy was basking in the glow of ultra-low interest rates. But now things are rapidly changing. On Wednesday, the yield on 10 year U.S. Treasuries hit 2.70% before falling back to 2.58% on “good news” from the Federal Reserve.
Historically speaking, rates are still super low, but what is alarming is that it looks like we hit a “bottom” last year and that interest rates are only going to go up from here. In fact, according to CNBC many experts believe that we will soon be pushing up toward the 3 percent mark…
Round numbers like 1,700 on the S&P 500 are well and good, but savvy traders have their minds on another integer: 2.75 percent
That was the high for the 10-year yield this year, and traders say yields are bound to go back to that level. The one overhanging question is how stocks will react when they see that number.
“If we start to push up to new highs on the 10-year yield so that’s the 2.75 level—I think you’d probably see a bit of anxiety creep back into the marketplace,” Bank of America Merrill Lynch’s head of global technical strategy, MacNeil Curry, told “Futures Now” on Tuesday.
And Curry sees yields getting back to that level in the short term, and then some. “In the next couple of weeks to two months or so I think we’ve got a push coming up to the 2.85, 2.95 zone,” he said.
This rise in interest rates has been expected for a very long time – it is just that nobody knew exactly when it would happen. Now that it has begun, nobody is quite sure how high interest rates will eventually go. For some very interesting technical analysis, I encourage everyone to check out an article by Peter Brandt that you can find right here.
And all of this is very bad news for stocks. The chart below was created by Chartist Friend from Pittsburgh, and it shows that stock prices have generally risen as the yield on 10 year U.S. Treasuries has steadily declined over the past 30 years…
When interest rates go down, that spurs economic activity, and that is good for stock prices.
So when interest rates start going up rapidly, that is not a good thing for the stock market at all.
The Federal Reserve has tried to keep long-term interest rates down by wildly printing money and buying bonds, and even the suggestion that the Fed may eventually “taper” quantitative easing caused the yield on 10 year U.S. Treasuries to absolutely soar a few weeks ago.
So the Fed has backed off on the “taper” talk for now, but what happens if the yield on 10 year U.S. Treasuries continues to rise even with the wild money printing that the Fed has been doing?
At that point, the Fed would begin to totally lose control over the situation. And if that happens, Bill Fleckenstein told King World News the other day that he believes that we could see the stock market suddenly plunge by 25 percent…
Let’s say Ben (Bernanke) comes out tomorrow and says, ‘We are not going to taper.’ But let’s just say the bond market trades down anyway, and the next thing you know we go through the recent highs and a month from now the 10-Year is at 3%. And people start to realize they are not even tapering and the bond market is backed up….
They will say, ‘Why is this happening?’ Then they may realize the bond market is discounting the inflation we already have.
At some point the bond markets are going to say, ‘We are not comfortable with these policies.’ Obviously you can’t print money forever or no emerging country would ever have gone broke. So the bond market starts to back up and the economy gets worse than it is now because rates are rising. So the Fed says, ‘We can’t have this,’ and they decide to print more (money) and the bond market backs up (even more).
All of the sudden it becomes clear that money printing not only isn’t the solution, but it’s the problem. Well, with rates going from where they are to 3%+ on the 10-Year, one of these days the S&P futures are going to get destroyed. And if the computers ever get loose on the downside the market could break 25% in three days.
And as I have written about previously, we have seen a huge spike in margin debt in recent months, and this could make it even easier for a stock market collapse to happen. A recent note from Deutsche Bank explained precisely why margin debt is so dangerous…
Margin debt can be described as a tool used by stock speculators to borrow money from brokerages to buy more stock than they could otherwise afford on their own. These loans are collateralized by stock holdings, so when the market goes south, investors are either required to inject more cash/assets or become forced to sell immediately to pay off their loans – sometimes leading to mass pullouts or crashes.
But of much greater concern than a stock market crash is the 441 trillion dollar interest rate derivatives bubble that could implode if interest rates continue to rise rapidly.
Deutsche Bank is the largest bank in Europe, and at this point they have 55.6 trillion euros of total exposure to derivatives.
But the GDP of the entire nation of Germany is only about 2.7 trillion euros for a whole year.
We are facing a similar situation in the United States. Our GDP for 2013 will be somewhere between 15 and 16 trillion dollars, but many of our big banks have exposure to derivatives that absolutely dwarfs our GDP. The following numbers come from one of my previous articles entitled “The Coming Derivatives Panic That Will Destroy Global Financial Markets“…
Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)
Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)
Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)
Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)
Bank Of America
Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)
Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)
Total Assets: $114,693,000,000 (a bit more than 114 billion dollars – yes, you read that correctly)
Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)
That means that the total exposure that Goldman Sachs has to derivatives contracts is more than 362 times greater than their total assets.
And remember, the biggest chunk of those derivatives contracts is made up of interest rate derivatives.
Just imagine what would happen if a life insurance company wrote millions upon millions of life insurance contracts and then everyone suddenly died.
What would happen to that life insurance company?
It would go completely broke of course.
Well, that is what our major banks are facing today.
They have written trillions upon trillions of dollars worth of interest rate derivatives contracts, and they are betting that interest rates will not go up rapidly.
But what if they do?
And the truth is that interest rates have a whole lot of room to go up. The chart below shows how the yield on 10 year U.S. Treasuries has moved over the past couple of decades…
As you can see, the yield on 10 year U.S. Treasuries was hovering around the 6 percent mark back in the year 2000.
Back in 1990, the yield on 10 year U.S. Treasuries hovered between 8 and 9 percent.
If we return to “normal” levels, our financial system will implode. There is no way that our debt-addicted system would be able to handle it.
So watch the yield on 10 year U.S. Treasuries very carefully. It is the most important number in the entire U.S. economy.
If that number gets too high, the game is over.
Have you ever seen a disaster movie that is so bad that it is actually good? Well, that is exactly what Syfy’s new television movie entitled “Sharknado” is. In the movie, wild weather patterns actually cause man-eating sharks to come flying out of the sky. It sounds absolutely ridiculous, and it is. You can view the trailer for the movie right here. Unfortunately, we are witnessing something just as ridiculous in the real world right now. In the United States, the mainstream media is breathlessly proclaiming that the U.S. economy is in great shape because job growth is “accelerating” (even though we actually lost 240,000 full-time jobs last month) and because the U.S. stock market set new all-time highs this week. The mainstream media seems to be absolutely oblivious to all of the financial storm clouds that are gathering on the horizon. The conditions for a “perfect storm” are rapidly developing, and by the time this is all over we may be wishing that flying sharks were all that we had to deal with. The following are 10 reasons why the global economy is about to experience its own version of “Sharknado”…
#1 The financial situation in Portugal continues to deteriorate thanks to an emerging political crisis. It all began last week when Portuguese finance minister Vitor Gaspar resigned…
“Mr. Gaspar’s resignation on July 1 has opened a Pandora’s box,” says Nicholas Spiro, managing director of Spiro Sovereign Strategy. “Portuguese politicians from the President down are treating the exit of Mr. Gaspar, the architect of the fiscal and structural reforms demanded by the troika, as a green light for a public debate about the bail-out programme. Yet the manner in which this debate is taking place, with the President undermining the prime minister and the opposition leader seeking to renegotiate the terms of the programme, is spooking markets.”
The general population is becoming increasingly restless as the nation plunges down the exact same path that Greece has gone. Nobody seems to have any solutions as the economic problems continue to escalate. According to Reuters, the president of Portugal has added fuel to the fire by calling for early elections next year…
Portugal’s president threw the bailed-out euro zone country into disarray on Thursday after rejecting a plan to heal a government rift, igniting what critics called a “time bomb” by calling for early elections next year.
Due to all of this instability in Portugal, the yield on Portuguese bonds shot up to 7.51% this week. That is a very bad sign.
#2 The economic depression in Greece continues to deepen, and it is being reported that Greece will not even come close to hitting the austerity targets that it was supposed to hit this year…
A leaked report from the European Commission confirms that Greece will miss its austerity targets yet again by a wide margin. It alleges that Greece lacks the “willingness and capacity” to collect taxes. In fact, Athens is missing targets because the economy is still in freefall and that is because of austerity overkill. The Greek think-tank IOBE expects GDP to fall 5pc this year. It has told journalists privately that the final figure may be -7pc.
Another 7 percent contraction for the Greek economy?
It has already been contracting steadily for years.
At this point, it would be hard to overstate how bad economic conditions inside Greece are. The following is from a recent article by Simon Black…
My friend Illias took a drag of his cigarette as he contemplated my question.
“Our government tells us that this will be a better year. No one really believes them. But all we can do is be optimistic. Too many people are committing suicide.”
His statement probably best sums up the situation in Greece right now. It’s as if the hopelessness has gone stale, and the only thing they have to replace it with is desperate, misguided, faux-optimism. And anger.
There are roughly 11 million people in this country. 3.4 million of them are employed, of which roughly one third work for the government.
1.34 million people are ‘officially’ unemployed. To put this in context, it would be as if there were 36 million officially unemployed in the US.
More startling, if you add the number of ‘inactive’ workers (i.e. those who gave up looking), the total number of unemployed is roughly 57% of the entire Greek work force.
#3 The economic crisis in the third largest country in the eurozone, Italy, has taken another turn for the worse. The unemployment rate in Italy is up to 12.2 percent, which is the highest in 35 years. An average of 134 retail outlets are shutting down in Italy every single day, and the debt of the country has been downgraded again to just above junk status…
Italy’s slow crisis is again flaring up. Its debt trajectory has punched through the danger line over the past two years. The country’s €2.1 trillion (£1.8 trillion) debt – 129pc of GDP – may already be beyond the point of no return for a country without its own currency.
Standard & Poor’s did not say this outright when it downgraded the country to near-junk BBB on Tuesday. But if you read between the lines, it is close to saying the game is up for Italy.
#4 There are rumors that some of the biggest banks in the world are in very serious trouble. For example, Jim Willie (a financial writer who usually puts out really solid information) is insisting that Deutsche Bank is on the verge of collapse…
The best information coming to my desk indicates that three major Western banks are under constant threat of failure overnight, every night, forcing extraordinary measures to avoid failure. They are Deutsche Bank in Germany, Barclays in London, and Citibank in New York. Judging from the ongoing defense from prosecution and cooperation (flipped) with Interpol and distraction of resources, the most likely bank to die next is Deutsche Bank. They are caught with accounting fraud and outright financial fraud over collateral shell games, pertaining to USTreasury Bonds, other sovereign bonds in Southern Europe, and OTC derivatives linked to FOREX currency contracts. D-Bank is a dead man walking.
Time will tell if he is right. But without a doubt the global financial system is extremely vulnerable right now.
Most Americans assume that the problems that caused the financial crash of 2008 were fixed, but that is most definitely NOT the case. In fact, our financial system is far more shaky today than it was just before the last financial crisis. When one major bank goes down, we could start to see others fall like dominoes.
#5 Just before the financial crisis of 2008, the price of oil spiked dramatically. Well, it is starting to happen again. The price of oil hit $106 a barrel on Friday. If the price of oil continues to rise at this pace, it is going to mean big trouble for economies all over the planet.
And as I wrote about recently, every time the average price of a gallon of gasoline in the United States has risen above $3.80 during the past three years, a stock market decline has always followed.
The average price of a gallon of gasoline in the United States reached $3.55 on Friday. This is a number to keep a close eye on.
#6 Mortgage rates are absolutely skyrocketing right now…
The average U.S. rate on the 30-year fixed mortgage rose this week to 4.51%, a two-year high. Rates have been rising on expectations that the Federal Reserve will slow its bond purchases this year.
Mortgage buyer Freddie Mac said Thursday that the average on the 30-year loan jumped from 4.29% the previous week. Just two months ago, it was 3.35% — barely above the record low of 3.31%.
This threatens to throw the U.S. real estate market into a slowdown worse than anything we have seen since the last recession.
#7 This upcoming corporate earnings season is shaping up to be an extremely disappointing one. In fact, the percentage of companies issuing negative earnings guidance for this quarter is at a level that we have never seen before.
So is this a sign that economic activity is starting to slow down significantly?
#8 U.S. stocks are massively overextended right now. In fact, according to Graham Summers, this is the most overextended stocks have been in the past 20 years…
Today, the S&P 500 is sitting a full 30% above its 200-weekly moving average. We have NEVER been this overextended above this line at any point in the last 20 years.
#9 Rapidly rising interest rates are causing the bond market to begin to come apart at the seams. There is concern that the 30 year bull market for bonds is now over and investors are starting to pull their money out of the market at a staggering rate. In fact, 80 billion dollars was pulled out of bond funds during June alone.
#10 Rapidly rising interest rates could cause an implosion of the derivatives market at any moment. As I am so fond of reminding everyone, there are approximately 441 trillion dollars worth of interest rate derivatives out there.
If interest rates continue to soar, we could potentially see a financial disaster that is absolutely unprecedented, and the too big to fail banks would be the most vulnerable.
As USA Today recently reported, there are just five major banks that absolutely dominate derivatives trading in the United States…
Five of the biggest U.S. banks — JPMorgan, Goldman Sachs Group Inc., Bank of America Corp., Citigroup Inc. and Morgan Stanley — account for more than 90% of derivatives contracts. Regulators estimate that nearly half of derivatives are traded outside the United States.
Could you imagine the financial devastation that we would see if several of those banks started to collapse at the same time?
When you hear the mainstream media begin to talk about a “derivatives crisis” involving major banks, that will be a sign that disaster is upon us.
Most Americans don’t realize that Wall Street has been transformed into the largest casino in the history of the world. Most Americans don’t realize that the major banks are literally walking a financial tightrope each and every day.
All it is going to take is one false step and we will be looking at a financial crisis even worse than what happened back in 2008.
So enjoy this little bubble of false prosperity while you can.
It is not going to last for too much longer.
Do you want to know the primary reason why rapidly rising interest rates could take down the entire global financial system? Most people might think that it would be because the U.S. government would have to pay much more interest on the national debt. And yes, if the average rate of interest on U.S. government debt rose to just 6 percent (and it has actually been much higher in the past), the federal government would be paying out about a trillion dollars a year just in interest on the national debt. But that isn’t it. Nor does the primary reason have to do with the fact that rapidly rising interest rates would impose massive losses on bond investors. At this point, it is being projected that if U.S. bond yields rise by an average of 3 percentage points, it will cause investors to lose a trillion dollars. Yes, that is a 1 with 12 zeroes after it ($1,000,000,000,000). But that is not the number one danger posed by rapidly rising interest rates either. Rather, the number one reason why rapidly rising interest rates could cause the entire global financial system to crash is because there are more than 441 TRILLION dollars worth of interest rate derivatives sitting out there. This number comes directly from the Bank for International Settlements – the central bank of central banks. In other words, more than $441,000,000,000,000 has been bet on the movement of interest rates. Normally these bets do not cause a major problem because rates tend to move very slowly and the system stays balanced. But now rates are starting to skyrocket, and the sophisticated financial models used by derivatives traders do not account for this kind of movement.
So what does all of this mean?
It means that the global financial system is potentially heading for massive amounts of trouble if interest rates continue to soar.
Today, the yield on 10 year U.S. Treasury bonds rocketed up to 2.66% before settling back to 2.55%. The chart posted below shows how dramatically the yield on 10 year U.S. Treasuries has moved in recent days…
Right now, the yield on 10 year U.S. Treasuries is about 30 percent above its 50 day moving average. That is the most that it has been above its 50 day moving average in 50 years.
Like I mentioned above, we are moving into uncharted territory and this data doesn’t really fit into the models used by derivatives traders.
The yield on 5 year U.S. Treasuries has been moving even more dramatically…
Last week, the yield on 5 year U.S. Treasuries rose by an astounding 37 percent. That was the largest increase in 50 years.
Once again, this is uncharted territory.
If rates continue to shoot up, there are going to be some financial institutions out there that are going to start losing absolutely massive amounts of money on interest rate derivative contracts.
So exactly what is an interest rate derivative?
The following is how Investopedia defines interest rate derivatives…
A financial instrument based on an underlying financial security whose value is affected by changes in interest rates. Interest-rate derivatives are hedges used by institutional investors such as banks to combat the changes in market interest rates. Individual investors are more likely to use interest-rate derivatives as a speculative tool – they hope to profit from their guesses about which direction market interest rates will move.
They can be very complicated, but I prefer to think of them in very simple terms. Just imagine walking into a casino and placing a bet that the yield on 10 year U.S. Treasuries will hit 2.75% in July. If it does reach that level, you win. If it doesn’t, you lose. That is a very simplistic example, but I think that it is a helpful one. At the heart of it, the 441 TRILLION dollar derivatives market is just a bunch of people making bets about which way interest rates will go.
And normally the betting stays very balanced and our financial system is not threatened. The people that run this betting use models that are far more sophisticated than anything that Las Vegas uses. But all models are based on human assumptions, and wild swings in interest rates could break their models and potentially start causing financial losses on a scale that our financial system has never seen before.
We are potentially talking about a financial collapse far worse than anything that we saw back in 2008.
Remember, the U.S. national debt is just now approaching 17 trillion dollars. So when you are talking about 441 trillion dollars you are talking about an amount of money that is almost unimaginable.
Meanwhile, China appears to be on the verge of another financial crisis as well. The following is from a recent article by Graham Summers…
China is on the verge of a “Lehman” moment as its shadow banking system implodes. China had pumped roughly $1.6 trillion in new credit (that’s 21% of GDP) into its economy in the last two quarters… and China GDP growth is in fact slowing.
This is what a credit bubble bursting looks like: the pumping becomes more and more frantic with less and less returns.
And Chinese stocks just experienced their largest decline since 2009. The second largest economy on earth is starting to have significant financial problems at the same time that our markets are starting to crumble.
And don’t forget about Europe. European stocks have had a very, very rough month so far…
The narrow EuroStoxx 50 index is now at its lowest in over seven months (-5.4% year-to-date and -12.5% from its highs in May) and the broader EuroStoxx 600 is also flailing lower. The European bank stocks pushed down to their lowest in almost 10 months and are now in bear market territory – down 22.5% from their highs. Spain and Italy are now testing their lowest level in 9 months.
So are the central banks of the world going to swoop in and rescue the financial markets from the brink of disaster?
At this point it does not appear likely.
As I have written about previously, the Bank for International Settlements is the central bank for central banks, and it has a tremendous amount of influence over central bank policy all over the planet.
The other day, the general manager of the Bank for International Settlements, Jaime Caruana, gave a speech entitled “Making the most of borrowed time“. In that speech, he made it clear that the era of extraordinary central bank intervention was coming to an end. The following is one short excerpt from that speech…
“Ours is a call for acting responsibly now to strengthen growth and avoid even costlier adjustment down the road. And it is a call for recognizing that returning to stability and prosperity is a shared responsibility. Monetary policy has done its part. Recovery now calls for a different policy mix – with more emphasis on strengthening economic flexibility and dynamism and stabilizing public finances.”
Monetary policy has done its part?
That sounds pretty firm.
And if you read the entire speech, you will see that Caruana makes it clear that he believes that it is time for the financial markets to stand on their own.
But will they be able to?
As I wrote about yesterday, the U.S. financial system is a massive Ponzi scheme that is on the verge of imploding. Unprecedented intervention by the Federal Reserve has helped to prop it up for the last couple of years, and there is a lot of fear in the financial world about what is going to happen once that unprecedented intervention is gone.
So what happens next?
Well, nobody knows for sure, but one thing seems certain. The last half of 2013 is shaping up to be very, very interesting.
If yields on U.S. Treasury bonds keep rising, things are going to get very messy. As I write this, the yield on 10 year U.S. Treasures has risen to 2.51 percent. If that keeps going up, it is going to be like a mile wide lawnmower blade devastating everything in its path. Ben Bernanke’s super low interest rate policies have systematically pushed investors into stocks and real estate over the past several years because there were few other places where they could get decent returns. As this trade unwinds (and it will likely not be in an orderly fashion), we are going to see unprecedented carnage. Stocks, ETFs, home prices and municipal bonds will all be devastated. And of course that will only be the beginning. What we are ultimately looking at is a sell off very similar to 2008, only this time we will have to deal with rising interest rates at the same time. The conditions for a “perfect storm” are rapidly developing, and if something is not done we could eventually have a credit crunch unlike anything that we have ever seen before in modern times.
At the moment, perhaps the most important number in the financial world is the yield on 10 year U.S. Treasuries. A lot of investors are really concerned about how rapidly it has been rising. For example, Patrick Adams, a portfolio manager at PVG Asset Management, was quoted in USA Today as saying the following on Friday…
“I am watching the 10-year U.S. bond,” says Adams. “It has to stabilize. If the yield goes significantly higher the market is going to freak out.”
If interest rates keep rising, it is going to have a dramatic effect throughout the economy. In an article that he just posted, Charles Hugh Smith explained some of the things that we might soon see…
The wheels fall off the entire financialized debtocracy wagon once yields rise. There’s nothing mysterious about this:
1. As interest rates/yields rise, all the existing bonds paying next to nothing plummet in market value
2. As mortgage rates rise, there’s nobody left who can afford Housing Bubble 2.0 prices, so home prices fall off a cliff
3. Once you can get 5+% yield on cash again, few people are willing to risk capital in the equities markets in the hopes that they can earn more than 5% yield before the next crash wipes out 40% of their equity
4. As asset classes decline, lenders are wary of loaning money against these assets; if the collateral for the loan (real estate, bonds, stocks, etc.) are in a waterfall decline, no sane lender will risk capital on a bet that the collateral will be sufficient to cover losses should the borrower default.
In addition, rapidly rising interest rates would throw the municipal bond market into absolute chaos. In fact, according to Reuters, nearly 2 billion dollars worth of municipal bond sales were postponed on Thursday because of rising rates…
The possibility of rising interest rates rocked the U.S. municipal bond market on Thursday, with prices plunging in secondary trade, investors selling off the debt, money pouring out of mutual funds and issuers postponing nearly $2 billion in new sales.
“The market got crushed,” said Daniel Berger, an analyst at Municipal Market Data, a unit of Thomson Reuters, about the widespread sell-off.
We are rapidly moving into unprecedented territory. Nobody is quite sure what comes next. One financial professional says that municipal bond investors “are in for the shock of their lives”…
“Muni bond investors are in for the shock of their lives,” said financial advisor Ric Edelman. “For the past 30 years there hasn’t been interest rate risk.”
That risk can be extreme. A one-point rise in the interest rate could cut 10 percent of the value of a municipal bond with a longer duration, he said.
Many retail buyers, though, are not ready for the change and “when it starts, it will be too late for them to react,” he said, adding that he was encouraging investors to look at their portfolio allocation and make changes to protect themselves from interest rate risks now.
Rising interest rates are playing havoc with other financial instruments as well. For example, it appears that the ETF market may already be broken. Just check out the chaos that we witnessed on Thursday…
The selling also caused disruptions in the plumbing behind several ETFs. Citigroup stopped accepting orders to redeem underlying assets from ETF issuers, after one trading desk reached its allocated risk limits. One Citi trader emailed other market participants to say: “We are unable to take any more redemptions today . . . a very rare occurrence due to capital requirements we are maxed out on the amount of collateral we have out.”
State Street said it would stop accepting cash redemption orders for municipal bond products from dealers. Tim Coyne, global head of ETF capital markets at State Street, said his company had contacted participants “to say we were not going to do any cash redemptions today”. But he added that redemptions “in kind” were still taking place.
These are the kinds of things that you would expect to see at the beginning of a financial panic.
And when there is fear in the marketplace, credit can dry up really quickly.
So are we headed for a major liquidity crisis? Well, that is what Chris Martenson believes is happening…
The early stage of any liquidity crisis is a mad dash for cash, especially by all of the leveraged speculators. Anything that can be sold is sold. As I scan the various markets, all I can find is selling. Stocks, commodities, and equities are all being shed at a rapid pace, and that’s the first clue that we are not experiencing sector rotation or other artful portfolio-dodging designed to move out of one asset class into another (say, from equities into bonds).
The bursting of the bond bubble has the potential to plunge our financial system into a crisis that would be even worse than we experienced back in 2008. Unfortunately, as Ambrose Evans-Pritchard recently noted, the bond market is dominated by just a few major players…
The Fed, the ECB, the Bank of England, the Bank of Japan, et al, own $10 trillion in bonds. China, the petro-powers, et al, own another $10 trillion. Between them they have locked up $20 trillion, equal to roughly 25pc of global GDP. They are the market. That is why Fed taper talk has become so neuralgic, and why we all watch Chinese regulators for every clue on policy.
This is one of the reasons why I write about China so much. China has a tremendous amount of leverage over the global financial system. If China starts selling bonds at about the same time that the Fed stops buying bonds we could see a shift of unprecedented proportions.
Sadly, most Americans have absolutely no idea how vulnerable the financial system is.
Most Americans have absolutely no idea that our system of finance is a house of cards built on a foundation of risk, debt and leverage.
Most Americans have complete and total faith that our leaders know what they are doing and are fully capable of keeping our financial system from collapsing.
In the end, most Americans are going to be bitterly, bitterly disappointed.