ANATOMY OF A DEBT CRISIS / MACLEOD FINANCE

Anatomy of a debt crisis

It’s amazing how complacent politicians and investors are about debt national problems. The main reason is they misunderstand the relationship between debt, risk, and interest rates.

ALASDAIR MACLEOD

It is an open secret that the global economy is tipping towards recession. 

On the basis that interest rates and bond yields are controlled by central banks, this allows investors to assume that if the recession does materialise, the authorities will simply cut interest rates to guarantee a soft landing. 

The can will be kicked down the road, as it always has been, preventing past recessions from being anything other than shallow.

The exception was the so-called great financial crisis of 2008/09, when there was a momentary deep recession. 

But just to prove the efficacy of central bank policy, the Fed did what it always does — cut the Fed Funds Rate aggressively from 5% to ¼%. 

But the other thing it did was write open cheques to the banks, underwriting and guaranteeing the entire US banking system.

While the cut in rates undoubtedly helped, it was the open cheque policy which mattered more. 

Bankers had stared into the abyss and heaved a sigh of relief, not calling in their loans. 

They had, in fact, been remarkably reckless — caught up in a collective groupthink over residential property loan syndications. 

They had stopped pricing risk as they should have done. 

And having been caught out put the relationship between risk and its proper pricing on the back burner.

The situation today is very different.

US banks have generally survived the increase in interest rates from the zero bound to current levels. 

True, there have been a few casualties in regional banks stupid enough to think that interest rates and bond yields would never rise again. 

That was over two years ago. Since then, banks have become significantly wiser about risk, pre-emptively redirecting credit towards US T-bills and away from risky private enterprises. 

This is why bank credit growth has slowed, with Loans & Leases growing at only 2.5% annually over the last two years, some of this growth fuelling speculative margin accounts in financial markets. 

For Main Street, in real terms bank lending has contracted.

Unwinding credit to private sector borrowers is a clog yet to drop. 

But as evidence of recession mounts, banks will become increasingly concerned over their borrowers’ prospects. 

And the damage inflicted by the US administration’s tariff policies is an additional factor of which banks are already aware.

The point is that this time, it’s not like previous downturns, nor is it like the Great Financial Crisis. 

Banks are much more aware of lending risk, which means that by increasing their overall lending exposure to the Federal Government’s T-bills they are derisking their balance sheets. 

And to the extent that they are on the hook for zombies and overleveraged customers which would go under if loan facilities were withdrawn, they are minimising their exposure and charging higher lending rates.

We are observing a phenomenon common to the cycle of bank credit.

It propels the cycle downwards, just as lending exuberance earlier in the cycle propelled it upwards. 

But I recall Gordon Pepper, who was the leading gilt-edged expert in the 1970s observed at that time that by switching assets into bank’s short-dated gilts often turned to be badly timed because they were buying instruments whose values declined.

We shall see if that holds today.

Foreign funding considerations

Domestic banks are only one source of credit open to governments. 

The other is foreign governments and investors evaluating as to whether they should offer finance by buying bonds. 

Obviously, they will look at lending risk very differently from a domestic, regulated bank which a government might coerce into buying its debt.

For a start, a foreigner takes a currency risk which a domestic bank does not. 

And a foreign investor tends to look at an investment opportunity in a far wider context, comparing the opportunity in one currency with others. 

In other words, a government like the US has to compete for funds to the extent that it relies on foreign investors to finance its debts.

Since the Bretton Woods Agreement in 1944, by ensuring that all currencies were fixed against the dollar, it gained a monopolistic demand for international liquidity. 

Initially, that led to the failure of the Bretton Woods system, as the expansion of dollar credit led to a glut in foreign hands. 

The replacement of gold by the dollar in 1971 as the cornerstone of international currency value led to the further expansion of dollar debt to another saturation point, which is the position today.

Put simply, we are arriving at a second “Bretton Woods moment” when foreign faith in US debt is failing again. 

And no wonder. 

Apart from distrust of President Trump’s tariff and foreign policies, there is the mathematics of a debt trap. 

Put simply, if debt is growing faster than the revenue to pay for it, then new debt will find no buyers. 

If there are no buyers, then attempts to entice them with higher interest rates and bond yields merely serve to confirm the arithmetic.

With the US economy doubtless tipping into a self-inflicted recession, this is the position that the US Treasury finds itself in. 

Bond yields and interest rates will not fall, as President Trump and the entire domestic investment industry believes, but they can only rise.

This is why on Trump’s “liberation day” when he announced punitive and seemingly random tariffs against the rest of the world, the dollar’s trade-weighted index collapsed, and bond yields rose. 

This is illustrated in the following chart.

After the initial shock, there has been a pause, responding to Trump backing down and announcing a 90-day delay in tariffs being imposed. Reasoned analysis should inform us that the damage in confidence has been done irreversibly, and shortly the dollar’s TWI will continue to collapse and bond yields continue to rise. 

For the US Treasury and the Fed, this is the worst possible outcome.

It is no accident that this analysis is being dramatically confirmed by the price of gold, which so far as the authorities are concerned has spiralled out of control. 

More accurately, it is foreign central banks taking fright at the prospects for the dollar and the implications for the entire fiat currency system. 

Asian central banks have seen this coming for some time, illustrated next.

The latest development is for Asian nations to seek protection from a coming dollar crisis. 

China has announced that the Shanghai Gold Exchange will open vaults abroad and both Hong Kong and Saudi Arabia with be the first sites. 

Gold can be traded with yuan instruments. 

In other words, gold is being linked to the offshore yuan at a floating rate initially, which can be fixed at a later date.

Clearly, the yuan is being lined up as an international gold substitute, displacing the fiat dollar. 

The agreement with Saudi Arabia is the clearest evidence of the way things are growing. 

And we should welcome any stability it brings to international affairs in a post-dollar world.