Expect a doom loop to spell a stagflationary debt crisis

This basic principle, known as ‘duration risk’, seems to have been lost on many bankers, fixed-income investors and bank regulators. As rising inflation in 2022 led to higher bond yields, 10-year Treasuries lost more value (-20%) than the S&P 500 (-15%), and anyone with long-duration fixed-income assets denominated in dollars or euros was left holding the bag. The consequences for these investors have been severe. By the end of 2022, US banks’ unrealized losses on securities had reached $620 billion, about 28% of their total capital of $2.2 trillion.

Making matters worse, higher interest rates have reduced the market value of banks’ other assets as well. If you make a 10-year bank loan when long-term interest rates are 1%, and those rates then rise to 3.5%, the value of that loan will fall. Accounting for this implies that US banks’ unrealized losses actually amount to $1.75 trillion, or 80% of their capital. The unrealized nature of these losses is merely an artefact of the regulatory regime, which allows banks to value securities and loans at their face value rather than market value. Judging by the quality of their capital, most US banks are technically near insolvency and hundreds are fully insolvent.

To be sure, rising inflation reduces the true value of bank liabilities (deposits) by upping their ‘deposit franchise’, an asset that is not on their balance sheet. Since banks still pay near 0% on most of their deposits, even though overnight rates have risen to 4% or more, this asset’s value rises when interest rates are higher. Indeed, some estimates suggest that rising rates have increased US banks’ total deposit-franchise value by about $1.75 trillion. But this asset exists only if deposits remain with banks as rates rise, and we now know from Silicon Valley Bank and other US regional banks that such stickiness is far from assured. If depositors flee, the deposit franchise evaporates, and the unrealized losses on securities must be realized as banks sell them to meet withdrawal demands. Bankruptcy then becomes unavoidable.

Moreover, the deposit-franchise argument assumes that most depositors are dumb and will keep their money in accounts bearing near 0% interest when they could be earning 4% or more in safe money-market funds that invest in short-term Treasuries. But, again, we saw that depositors are not so complacent. The persistent flight of deposits is probably being driven as much by depositors’ pursuit of higher returns as by their concerns about the safety of their deposits.

In short, after being a non-factor for the last 15 years, the interest-rate sensitivity of bank deposits has returned to salience. Banks assumed a foreseeable duration risk because they wanted to fatten their net-interest margins. They seized on the fact that while capital charges on government-bond and mortgage-backed securities were zero, the losses on such assets did not have to be marked to market. Regulators did not even subject banks to stress tests to see how they would fare in a scenario of sharply rising interest rates.

Now that this house of cards is collapsing, the credit crunch caused by banking stress will create a harder landing for the real economy, given the role that regional banks play. Central banks face not just a dilemma, but a trilemma. Owing to recent negative aggregate supply shocks, achieving price stability through interest-rate hikes was bound to raise the risk of a hard landing (a recession and higher unemployment). But this trade-off also features the risk of severe financial instability.

Borrowers are facing rising rates on new borrowing and existing liabilities that have matured and need to be rolled over. But the increase in long-term rates is also leading to massive losses for creditors holding long-duration assets. As a result, the US economy is falling into a debt trap, with high public deficits and debt causing fiscal dominance over monetary policy, and high private debts causing financial dominance over monetary and regulatory authorities.

As I have long warned, central banks confronting this trilemma will likely wimp out (by curtailing monetary-policy normalization) to avoid a financial meltdown, and the stage will be set for a de-anchoring of inflation expectations. Central banks must not delude themselves into thinking they can still achieve both price and financial stability through some kind of separation principle (raising rates against inflation while using liquidity support for financial stability). In a debt trap, higher policy rates will fuel systemic debt crises that liquidity support will be insufficient to resolve.

Central banks also must not assume that the coming credit crunch will kill inflation by reining in demand. After all, supply shocks persist and labour markets remain too tight. A severe recession is the only thing that can temper price and wage inflation, but it will worsen the debt crisis, which may cause a deeper downturn. Since liquidity support can’t prevent this systemic doom loop, everyone should prepare for a stagflationary 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’