I looked at US credit risk through Credit Default Swaps (CDS) in the previous two posts. Today I examine how a sharp upward revision of US credit risk could impact the global financial market through OTC derivatives on interest rates.
The Bank for International Settlements (BIS) publishes a comprehensive survey every three years on such derivatives - the last one was for 2019. It also provides summary data every six months.
As you can see below, the daily turnover for Over The Counter (OTC - not exchange-traded) dollar interest rate derivatives was approx. $3.3 trillion in 2019. Volume rose sharply since 2013 and as of the second half of 2020 the notional amount of such dollar derivatives outstanding was $152 trillion with a market value of $2.5 trillion.
If anything unexpected were to happen to US interest rates - say, from a sudden negative revaluation of credit risk - the upheaval on the derivatives market and through them to the entire financial system and the global economy would be very serious.
Let’s look at an example for an interest rate swap. In such a derivative the counterparties agree to exchange interest payments between a short term benchmark and a long term benchmark (eg 3 months vs. 3 years). It’s the commonest way to manage yield curve risk by turning a variable rate into a fixed one and vice versa.
Can you imagine what will happen if the US goes into some sort of technical default and the dollar yield curve goes bananas, either by becoming grossly inverted or steepens explosively? The IRSs (and FRAs) will certainly blow up, all $152 trillion of them. And those are just the ones denominated in dollars, the market in euros will definitely be impacted as well - that’s another 132 trillion euro.
To put it into perspective, the notional amounts of dollar and euro interest rate derivatives amount to 860% of the combined GDP of the US and Eurozone. (If we include all currencies the notional outstanding comes to $466 trillion, or 550% of global GDP.)
Coda: The more things change, the more they stay the same...
During the Great Credit Bubble the major accelerator of its formation and eventual meltdown was the CDS market. It had grown tenfold (!!) from $6.4 trillion notional outstanding in 2004 to $61.2 trillion at its peak in 2007. Today it is a "mere" $8.4 trillion - people have learned their lesson, I guess.
Or have they?
Turnover in OTC dollar interest rate derivatives has grown from $639 billion per day in 2013, to $1.36 trillion in 2016 and $3.3 trillion in 2019. We do not have more recent BIS data, but given the explosion in money supply in the last two years I expect these numbers to have grown substantially.
Keep in mind that these numbers do not include dollar interest rate derivatives traded on exchanges, eg futures and options on bonds - these come to an additional $5 trillion per day.
Therefore, the total turnover in dollar interest rate derivatives comes to $8.3 trillion notional per day. That's a very, very big market and we really, really do not want to upset it. Really. So, ladies and gentlemen of the US Administration and Congress, keep this in mind as you debate the debt limit. DNFΤU should rule your thoughts and actions.
Personally, I think that you are so irrevocably divided, even within your own parties, that you may end up creating a big mess. (Trump is going to run for President again, isn't he...)
I'm re-posting this comment from a previous post to facilitate discussion..
ReplyDeleteAKOC wrote:
"The wall street guys that are dealing with China are truly ill informed (to put it mildly). They are not dealing with someone who interested in making money with them; they are dealing with someone who is interested in eliminating them. The goal of the CCP is not to make money; it is to control money....
If you are in to stats; the percentage of Chinese leaders that came to a good end is incredibly small; I think around 1%.... of the top leadership, only Mao and Deng. A soldier likely has better odds surviving the battle of Somme."
I think people who understand geopolitics and the associated power games have no illusions about China. Maybe some financiers hope that China will transform into a more pluralistic Western type society, but I don't think they are too many of them, and certainly not at the top echelons.
Wall Street, and financial markets in general, have always been extremely short-term oriented. They may analyze long term, but they act minute to minute - literally. To put it in simple terms, analysts talk, traders act.
Traders live and breathe price action. If it goes up they buy. If it goes down they sell. It's all about momentum. And make no mistake: the people who rule finance are ALL traders - or have been in the past.
So, as far as China is concerned Wall Street will keep dancing until the very last second before the music stops. It's the nature of the beast...
There was a young lady of Niger
ReplyDeleteWho smiled as she rode on a tiger;
They returned from the ride
With the lady inside,
And the smile on the face of the tiger.
Btw, I like your market analysis. I dun say anything, cause I don't have anything to say. But just want you to know it is appreciated.
Thank you very much AKOC, I also appreciate the feedback and your fresh points of view.
DeleteAKOC, I hope you are not saying 1.4b aspiring Chinese don't deserve to be 'rich'. Because on the path to 'richness' for 1.4b mouths, there'll bound to be friction with the hegemon, status quo, environment, etc. In the first place, is it even reasonable to expect a 5,000-year old civilisation state like China to become more like the US; barely 250-year old? That's just pure naivete. Is it possible for China to be the next 'USA' of the world without offending anyone? Not possible.
ReplyDeleteno, not at all..... and yes, for 1.4 billion to be rich, it will create a lot of friction... but the way we are doing it is not good for ourselves... and is not likely to make us rich.
DeleteI feel that there is no need to challenge the west directly. If we build genuine institutions of worth, the west will naturally be co-opted into our sphere. Sure, they are strong now and we are weak, so somethings will be unfair... but over time that will change... we have waited 500 years, what is another 50?
Western style democracy is failing at the moment, and it's not the fault of China. The way I see it, China has been advocating for trade, climate and win-win cooperation with the US and many other countries. It is promoting pluralism and globalization while the US is shunting it. Ironically, it recently even applied to join the CPTPP which the US pulled out last minute - much to the disappointment of its partners. China will become democratic under its own terms, time and definition. Yes, China 'cheated' and 'stole' to be where it is today - the largest economy in the world by PPP terms - but it has more or less complied with the regulations of WTO. Basically, it's not possible to please everyone in the West, and the rampant rise of sino-phobia and the manufacturing of consent for war by the media with China is concerning. The US can try to retard China's rise or contain it by starting the Pivot (under Obama), Trade War and 5G ban (under Trump), AUKUS (under Biden) and UST default (under AKOC which is also the 'unthinkable' as it would be the final act of decoupling & war), but we should also play fair and be realistic. Maybe the fault of the US is within and not foreign as you have highlighted. Alas, many in the West can't wait for 5 years let alone 50 years.
DeleteChina is promoting pluralism? The Uighurs would like a word... Taiwan? Tibet? Hong Kong? China is a totalitarian State, many people forget this.
DeleteWell, to answer SEG,
DeleteI agree with many of the points (which a lot of the West does not agree with). For example, the CCP is in many ways more responsive to the people than a Western democracy. So how I see it currently is that:
1) It is not in China's interest to attempt to take over from the west (at least not now).
2) It would be terrible for China if it actually succeeded.
I think point 1) is not controversial. The West is simply too strong. Even if China can win, it would cost too much.
Point 2) is more unique to myself... China's success so far is powered by people who are good at taking but not at building. They fill most of the leadership positions in tech, industry and politics. Such people live parasitically off the West. If China takes over now, they cannot maintain stability because their host is dead.
China is transitioning; the parasites are being weeded out and eventually there will be true builders. But this takes time. Things might look bad on paper, economic recession, company collapse... but they are growing pains, we need to weed out the bad that the new can grow.
Recommendation: Let us think of the west as our boss... We should not be explaining to our boss why he should not feel challenged... We should be going out of our way to make sure he does not feel challenged. Time is on our side...
After we win, we can send camabron for re-education... He clearly does not show proper appreciation for 5000 years of culture. =)
AKOC said...
Delete1)It is not in China's interest to attempt to take over from the west (at least not now).
2) It would be terrible for China if it actually succeeded.
_________________________________________________________
!. Overall, China WANTS to take over - or, at the very least, be on a par with the West. And when I say West I mean the US - The EU is, unfortunately, a geo-strategic midget.
"Taking over" is not an exact science and almost never happens according to a set time plan. It happens when it is possible, ie when the adversary is weak (or you think he is). I believe right now China's leadership see the US as very, very weak.
They observe the incredible political, social and economic chasm separating parties, the working poor and uber rich, the soaring debt necessary to maintain living standards. They see America's disregard for climate change, its abandoning not only Afghanistan (it would have happened, anyway), but even its oldest allies in Europe. They see a weak, old man taking over as President from an old, crazy man.
The Chinese are an ancient empire, they really understand the tides of time as few others on this planet. For better, or for worse...
2. China would have to assume the burden of global leadership, just like the US took over from Europe after WWI/WWII. I observe that, unlike the US now, China WANTS to do it, it really, really wants the job. I hope they don't screw it up.