Interest rates have risen significantly. Can the financial storm be far behind? Perhaps, but things are often not that simple.
This week, the yield of 10-year US treasury bond bonds rose above 5% for the first time since 2007. Although not high by historical standards, it has significantly increased compared to the level of less than 1% for most of 2020.
James Grant, founder and editor of Grant's Interest Rate Observer, said, "5% is almost the average level of investment grade interest rates since the era of Alexander Hamilton." He said, "The problem is the structure brought about by 10 years of ultra loose monetary policy. People attribute it to interest rate normalization. The previous abnormal interest rates were the problem
Since interest rates began to rise in 2022, we have experienced two rounds of thunderstorms caused by this. In the United States, soaring interest rates triggered several regional banks to fail earlier this year. A year ago, leveraged pension funds in the UK were hit by rising interest rates. In both cases, the government intervened to prevent the problem from spreading.
From a historical perspective, major fluctuations in monetary policy have increased the likelihood of financial market runaway. A study published in May this year analyzed the interest rate hikes of 17 developed countries over the past 150 years and concluded that "raising monetary policy interest rates after a series of interest rate cuts (or long-term low interest rates) would substantially increase crisis risk." A senior researcher and three co authors at the Bank of Spain referred to this as the "U-shaped currency interest rate path, It will increase the risk of banking crises through the credit and asset price cycles.
Sometimes, the causal relationship between rising interest rates and financial storms is very clear, while sometimes it is more ambiguous. Credit losses, liquidity constraints, and high leverage often play a crucial role, making it difficult to clearly distinguish the effects of different factors.
Below are some historical examples.
The Savings and Loan Crisis of the 1980s
In the late 1970s and early 1980s, the Federal Reserve raised interest rates in response to inflation, leading to a significant bankruptcy of the US savings and loan industry. The federal government has set deposit interest rates that savings institutions can pay, and many customers transfer funds to other places in search of higher returns.
At the same time, savings and loan institutions mainly provide long-term fixed rate housing loans. With the soaring interest rates, the market value of these assets has sharply declined. (First Republic Bank and Silicon Valley Bank, which went bankrupt this year, also experienced similar situations.) Regulators have kept the 'zombie savings institutions' going for years, and their financial situation is getting worse and worse. By the late 1980s, over 1000 savings institutions had collapsed and the US Congress had approved the taxpayer rescue plan.
Continental Illinois National Bank& Trust
In May 1984, Continental Illinois National Bank& Trust was the seventh largest bank in the United States when it encountered a global deposit run. At that time, the yield of 10-year US treasury bond bonds rose from just over 10% a year ago to over 13%. The bank had previously grown rapidly, issuing high-risk loans at rates below market levels even as interest rates soared. In 1981, a competitor in Chicago told the Wall Street Journal, "Even if the best interest rate is 20%, they can still provide a fixed rate loan of 16%. I don't know how they did it
The banking regulatory authorities ultimately provided billions of dollars in aid and guarantees for all depositors and creditors, making Continental Illinois the first "big and unbeatable" bank.
Black Monday
Post analysis of the global stock market crash caused by the 22.6% drop in the Dow on October 19, 1987 often points out that program trading strategies such as portfolio insurance and index arbitrage have snowballed into huge losses. Subsequently, margin calls emerged, and the computerized trading systems of that era were unable to handle such a large volume of transactions.
However, interest rates and money markets are key drivers. The exchange rate of the US dollar against the West German mark has been falling, and the yield of the 30-year US treasury bond bond soared from 7.5% in March to more than 10%. When interest rates rise, stocks often go down because the company's future profit value will shrink. But in the summer of that year, the stock market continued to rise, laying the groundwork for a significant decline in the future.
1994
The Federal Reserve surprised the market by doubling interest rates to 6% within 12 months. The interest rate hike triggered a decline in bond portfolios and a downturn in the Mexican economy, while at the same time, the exposure of a false trading profit scandal led to the collapse of Kidder Peabody, a Wall Street brokerage firm.
The above interest rate hikes include a 0.75 percentage point hike in November last year. The following month, Orange County, California filed for bankruptcy after a series of catastrophic incorrect interest rate bets. The head of the county's finance department resigned and later admitted to being guilty of fraud.
The Internet foam burst in 2000
Subsequently, internet stocks gained popularity, and speculators flocked to these large money burning companies without paying attention to investment fundamentals. There are many reasons for the bursting of the Internet stock foam.
But it is true that the Federal Reserve raised interest rates six times from June 1999 to May 2000. The last rate hike was half a percentage point, and the interest rate rose to 6.5%. At that time, the Internet foam had been punctured. By 2003, interest rates had dropped to 1%, laying the foundation for the low interest rates of most of the past 20 years.
Economic recession from 2007 to 2009
Here, the Federal Reserve is more accused of keeping interest rates too low for too long, rather than being criticized for being too high. From June 2004 to June 2006, the Federal Reserve raised interest rates 17 times, each by a quarter of a point. At a time when signs of a real estate downturn are emerging, the Federal Reserve has stopped raising interest rates. By 2007, the financial crisis began to erupt, and the Federal Reserve began to cut interest rates again later that year.
For millions of Americans, the impact of rising interest rates directly hits their core, as they borrow floating rate mortgages and adjust interest rates to higher levels after the extremely low initial interest rate expires. Usually, these customers can only afford the initially low interest rates, but the lending institutions do not care because they quickly package these loans into complex mortgage backed securities and sell them to investors.
The resulting credit losses may be more due to loose loan disbursement standards than rising interest rates. But the record breaking number of foreclosures is closely related to the reset of loan interest rates to higher levels.