Don’t Rule Out a Financial Crisis Just Yet
This may sound like a naive and rather unreasonable question at the moment, given that no one expects anything bad to happen, but it could be worth exploring: Is there a financial crisis in sight?
Possibly.
You see, there are currently a few factors at play that could shock the financial system. If that shock is strong enough, then don’t rule out a financial crisis.
Digging into the details…
Look at the chart below. It plots the amount of money going into the Federal Reserve’s overnight reverse repurchase agreements (ON RRPs). Chances are, you won’t see this chart much in the mainstream media.
What is an RRP? In the simplest words, it involves the Federal Reserve selling the U.S. Treasury instruments it holds to banks (and other authorized counterparties), with an agreement to buy these securities back at a later date.
(Source: “Overnight Reverse Repurchase Agreements: Treasury Securities Sold by the Federal Reserve in the Temporary Open Market Operations,” Federal Reserve Bank of St. Louis, last accessed July 15, 2021.)
Notice something in the above chart?
Over the past few weeks, RRPs have gotten a lot of attention. On a daily basis, we are seeing $800.0 billion worth of assets changing hands. Just recently, $1.0 trillion worth of assets changed hands through RRPs.
Here’s the thing: an RRP could be considered an instrument that drains some liquidity from the financial system. You really have to look at this and ask what will happen if the liquidity that’s been in the financial system starts to drain slowly. It could affect interest rates.
Interest-Rate Uncertainty Remains Elevated
RRPs are just one factor worth paying attention to.
For instance, look what has been happening to the yields on short-term bonds, specifically the three-year and five-year U.S. Treasuries. Yields on these bonds have surged significantly since the beginning of the year, and they remain elevated. Meanwhile, the yields on long-term bonds have been slowly dwindling. This creates tons of uncertainty regarding interest rates.
On top of all this, there’s lingering noise about inflation. At this point, everyone understands that it’s temporary and that there’s no way inflation could remain at its current level for too long. Is the transition period going to be a few months? A few quarters? With this, remember that inflation impacts bonds and interest rates.
Why We Could See a Financial Crisis
Looking at the broader picture…
Did you know that, at the end of the first quarter of 2021, U.S. banks had derivative contracts with a notional value of $137.4 trillion concentrated in interest rates? The top four banks in the U.S. combined hold $130.0 trillion of notional wealth in interest-rate derivatives. (Source: “Quarterly Report on Bank Trading and Derivatives Activities: First Quarter 2021,” Office of the Comptroller of the Currency, last accessed July 15, 2021.)
Imagine a situation where interest rates in the U.S. get whacked around. We already know the Federal Reserve isn’t trying to change them whatsoever, but what if the market forces and panicking investors create some hiccups in the bond market?
With this, would the immense number of derivatives in the financial system get impacted? Not all of the derivatives have to go bad. Just five percent to 10% of them going bad could cause a massive impact on the system.
And that could create a big financial crisis.