Keywords: High Inflation, Recession Risks, Insolvency Crisis, Central Banks, Federal Reserve, Trilemma, Severe Recession, Debt Crisis, Duration Risk

In today’s finance arena, we are wrestling with a trilemma: soaring and stubborn inflation, the threats of recession, and a looming insolvency crisis in the financial sector. This complex situation has left central banks like the US Federal Reserve in a tight spot. Can they simultaneously combat inflation and provide liquidity support? Unfortunately, it seems the only way out may be a severe recession – thus setting the stage for a broader debt crisis.

The Looming Threat

Cast your mind back to January 2022. Yields on US ten-year Treasury bonds were hovering around 1%, and those on German Bunds were at -0.5%. Back then, warnings were sounding that inflation could wreak havoc on both stocks and bonds. The theory was simple: Higher inflation would trigger higher bond yields, which would negatively impact stocks as the discount factor for dividends increased. Additionally, the inverse relationship between yields and bond prices meant that higher yields on “safe” bonds would lead to a drop in their price.

The principle at play here is “duration risk”, and it seems to have slipped under the radar of many bankers, fixed-income investors, and bank regulators. Inflation’s rise in 2022 led to higher bond yields, which resulted in ten-year Treasuries losing more value (-20%) than the S&P 500 (-15%). Those holding long-duration fixed-income assets in dollars or euros were left holding the proverbial bag. The fallout for these investors was substantial. By the end of 2022, US banks’ unrealized losses on securities had hit $620 billion, roughly 28% of their total capital ($2.2 trillion).

The pinch didn’t stop there. Higher interest rates have also shrunk the market value of banks’ other assets. For instance, if a bank gives out a ten-year loan when long-term interest rates are at 1%, and then rates increase to 3.5%, the actual value of that loan (what another market player would pay for it) will drop. Factoring this in reveals that US banks’ unrealized losses equate to $1.75 trillion, a staggering 80% of their capital.

Conclusion

We find ourselves teetering on the edge of a financial precipice, faced with the unenviable trilemma of high inflation, looming recession risks, and an impending insolvency crisis. This situation has left central banks around the world in a bind, pushing them toward the unpalatable option of a severe recession. This path, however, may also usher in a broader debt crisis.

How can we navigate this complex landscape? What measures can we take to avert these looming crises? I invite you to share your thoughts, questions, and suggestions in the comments section below. Your input is invaluable as we strive to understand and address this impending financial conundrum.