Markets On the Fast Track to Hitting a Wall
Beware of the tipping point in this economy, and the trillions of dollars that follow.
What has surprisingly received little media attention is that the US government has been steadily reducing the maturity of its treasury portfolio to keep fiscal deficits down. Whether interest rates rise or it becomes a problem for the US Treasury to re-fund the ever expanding rollover pools, both suggest a Maturity Wall is dead ahead. My analysis suggests it will occur no later than 2012, but it will likely be triggered earlier with the next financial default scare.
Everyone Has Gone Short Duration
Besides US government debt duration shortening, interest rate swaps with durations less than one year are equally alarming. The rate at which this duration has grown over the last 10 years for US banks is nearly parabolic. We now have $75 trillion in interest rate and foreign currency swaps in paper with less than one year duration held by US commercial banks. If interest rates begin to move toward Morgan Stanley's 2010 estimate of a 5.5% in the 10-Year US Treasury, watch out! You can expect dramatic market volatility when $75 trillion in derivative instruments requires realignment.
10-Year Interest Rate Swap Inversion Is Highly Unusual
Also getting little attention is the fact that the 10-Year Swap rate has now gone negative. This is an extremely unusual occurrence. According to the Financial Times "historically, yields on government bonds have traded at a discount to the derivative as swaps are money market instruments whereas Treasuries reflect triple A sovereign risk. Funding a swap trade over time is more expensive than Treasuries, but constraints on balance sheets make it difficult for traders to implement such trades. Swap rates and Treasury yields have been converging in recent weeks, driven by high government bond supply, and increased demand by investors using swaps for meeting long-dated liabilities rather than committing capital to buying bonds."
The Defunct Shadow Banking System Is Having Unintended Consequences
I've been wondering for some time about the real unintended consequences of the collapse of the Shadow Banking System. I read that Morgan Stanley analysts are likewise concerned and see the inversion in the 10-Year Swap spreads as an indicator. What seems to be going on here is that there's a mismatch in supply between what is on balance sheet as represented by US Treasuries supply and what is off balance sheet as represented by Libor supply. The "producers" of low Libor for years have been the supply from the Shadow Banking system through SIVs (Structured Investment Vehicles), which were heavily used by the banking industry for capital arbitrage and which generated short-term money. Sovereign deficits are causing growing sovereign debt supply growth; which is causing Swap Spreads to narrow and go negative; which will lead to increasing yields; which will see higher levels of both nominal and real interest rates.
Morgan Stanley states that "the issuance of UST debt is dwarfing Libor-related issuance. For example, we expect UST net issuance to be $1.7 trillion and net issuance of MBS to be zero. Thus, the relative issuance of USTs vs. Libor-based products mainly accounts for the inversion in swap spreads. This is a first sign of stress leading to higher UST yields and is not to be missed."
With $492 trillion outstanding in the notional value of global interest rate swaps it's reasonable to conclude that one of the counterparties in the trade will get hurt when rates rise. This suggests there is going to be significant "hurting" in a total global economy of only $45 trillion. All indications are that no later than 2012, the global economy is going to run headlong into a funding maturity wall. Markets always anticipate events at least six months in advance. This barrier is so huge I doubt the market will wait and will likely begin adjusting 12 to 14 months ahead! All bets are off if we get another sovereign or possible American state government default scare. This would move our Maturity Wall even closer in.
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