Why The Fed Is Trapped: A 1% Increase In Rates Would Result In Up To $2.4 Trillion Of Losses

Tyler Durden's picture

A funny thing happened as every central bank around the world rushed to stimulate their economy by devaluing their currency in a global FX war that is now 7 years old and getting more violent by the day: with bond yields plunging, and over $10 trillion in global debt now having a negative yield, every fixed income investor starved for yield was pushed into the long end of the bond curve where whatever yield is left in the world of "safe" bonds is to be found. As long as interest rates never go up, this strategy is relatively safe. However, a major risk emerges when central banks start tightening.

To be sure, banks have been eager to front-run any concerns about the Fed's rate hike by cheering higher rates as precisely what they need to be more profitable, and the market has so far believed and rewarded bank stocks the higher rate hike odds rose. Just this Thursday, speaking at an investor conference James Dimon said that if short-term and long-term rates were to move up by 1 percentage point simultaneously, 70% of the benefit would come from the move in short-term rates. The reason for this is that even if long-term rates remain under pressure, and the curve flattens further, an increase in short-term rates provides an immediate boost to bank profits. That is because many loans are automatically priced against short-term benchmarks like LIBOR and Prime.

What Dimon did not discuss is the P&L impact from the higher yields and dropping bond prices in the long end of the yield curve. And it is here, in the unprecedented duration exposure that central banks have forced everyone into, that the true risk resides.

How big is the risk? According to an analysis by Goldman's Charles Himmelberg, if rates rise by the Jamie Dimon-referenced 1 percentage point, the market value loss would be between $1 and $2.4 trillion! Putting this loss in context, even the smaller $1trn loss would be over 50% larger than the market value lost in the 1994 bond market selloff in inflation-adjusted terms, and larger than the cumulative credit losses experienced to date in the non-agency residential mortgage backed securities market. And this is only only as a result of a 1% interest rate increase: assuming full normalization of rates to their historical level of 3.5%, and the level of mark-to-market losses climbs to a staggering $3 trillion.

The culprit? The Fed, the same Fed which does not to grasp that by "renormalizing" into the biggest bond bubble in history is assuring massive losses for the financial sector.

The problem is simple: having inflated a gargantuan bond bubble, letting the air out would by definition lead to dramatic consequences not just for bonds but for all other asset classes.

As Goldman shows in the chart below, the growth in total debt outstanding, in constant 2015 dollars, has been unprecedented. The total face value of all US bonds, including Treasuries, Federal agency debt, mortgages, corporates, municipals and ABS, is $40 trillion (Securities Industry and Financial Markets Association). The Barclays US aggregate is a smaller number, $17 trillion, as the index excludes some categories of debt, such as money markets, with low duration. To end up with a more palatable number, Goldman uses the Barclays measure of debt outstanding, although it admits this may lead to an understatement of the total loss potential. Using either measure, total debt outstanding has grown by over 60% in real Dollars since 2000.

 

It is not just the notional amount of debt that has been relentlessly rising: as Exhibit 3 shows, the aggregate interest rate duration across the bond market has also increased over the past several years, up over 20% vs. the 1995-2005 average level. Longer durations are largely driven by lengthening maturities on the bonds outstanding, as issuers have elected to term out their debt structures. Exhibit 4 shows that the average maturity of corporate bonds issued in 2015 and 2016 is over 16 years,  vs. an average of 8.6 years during 1995-2005. The US Treasury has also chosen to lengthen its debt maturity structure, with more use of long duration bonds.

The secular decline in nominal interest rates has also contributed to the drift upward in bond duration.

In 1994, the average yield on the bond index was 5.6%, vs. 2.2% currently. Lower bond coupons means that proportionately more of the bond cashflows now comes from principal, which tends to be distributed towards the end of the bond lifetime.

Here is the math of how a 1% increase in rates would lead to trillions in losses.

Combining a duration estimate of 5.6 years with a total notional exposure of $17trn, and current Dollar price of bonds of $105.6, indicates that, to first order, a 100bp shock to interest rates would translate into a $1trn market value loss. That is using the more conservative estimate of the bond market. Using the broader bond market sizing of $40trn, the market value loss estimate would be $2.4 trillion. While Goldman believes that using the larger number "would likely be an overstatement, as much of the extra debt in the broader universe is either short maturity or floating rate", even the smaller $1 trillion loss estimate is large: over 50% larger than the market value lost in the 1994 bond market selloff in inflation-adjusted terms, and larger than the cumulative credit losses experienced to date in the non-agency residential mortgage backed securities market.

As Goldman concludes, "even if there is not a large net social loss from a rise in rates, the $1 trillion gross loss estimate suggests that some investor entities would likely experience significant distress. In the 1994 bond market decline, for example, losses on a mortgage derivative portfolio were a major factor contributing to the Orange County, California bankruptcy event. All in, the increase in total gross debt exposure, combined with lengthening bond durations and an arguably expensive bond market, suggest that rising yields should be on the short list of scenarios to be monitored by risk managers.

This ignores the losses that would also impact the Fed's own holdings of rates instruments: at last check the Fed's balance sheet had a DV01 of about $2.5 billion, or a $250 billion hit for every 1% increase in rates.

As Bloomberg adds, analysts and regulators have warned for months that rising rates will be painful for investors and lenders, but bond yields remain stubbornly low. Perhaps the reason for this is that "investors and lenders" realize that it is only a matter of time before the Fed understands it is trapped and as a result of these gargantuan losses that would be imposed on the financial industry, it simply can not hike rates. Alternatively, if there is indeed as much as $2.4 trillion in losses coming, then while bonds will be slammed, it is the equity that will be wiped out. And, as this market has demonstrated all too well, when equity selloffs start, the proceeds usually go right into bonds, making the bubble even bigger.

On the other hand, if the Fed - which has demonstated it is painfully clueless in these past few years - intends to push on with a rate hike despite a raging profits recession and a global economy that is one snowstorm away from contraction, then the trade is simple: take advantage of the algos' stupidity and short financials. Because far from "beneficiaries" of the Fed's tightening on the short end, as much as Jamie Dimon would disagree, it is the long end where the market's unprecedented duration risk is about to rear its ugly head if and when the Fed does try to "normalize."

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TradingIsLifeBrah's picture
TradingIsLifeBrah (not verified) Jun 4, 2016 1:58 PM

Well we do have 1 current rate hike to use as a comparison stat.  Someone could look at how equity and bond markets have performed since the Fed raises rates by 25bps and then multiply that by 4 to get the expected impact of a 1% rate hike.  That would be at least as reliable as a stat that Goldman and JP Morgue came up with.  Fundamentals haven't mattered in quite a while, market price impacts are most relevant to government officials and citizens at large.

Boris Alatovkrap's picture

No mystery. Trap for Fed and other Central Bank is "Duration Mismatch". Bankster is lend long, borrow short. ZIRP for more than a short time is terminal, end game. Not if, but just when.

… but what is Boris knowing?

MASTER OF UNIVERSE's picture

And given 'what is Boris knowing' we can assume that everyone in the CB & Treasury has known since March 10th 2008 that the Zero Sum End Game is based on the CB ineffectuality with regard to a centrally planned interest rate that is theoretically impossible to raise given the crash on the long bond if they do. Clearly, everyone and their brother must have seen this coming down the pike in 08, or 07. Greenspan, and Geithner, must have known that TBTF was theoretically the wrong way to turn in 08, and they knew the long bonds would eventually crash along with the entirety of the bond markets, and governments in the matrix, including the United States of America. They bought time to ringfence the toxic waste MBS, deleverage they own investments, and cash the fuck out before the bond markets imploded. And now we can expect that they will bug out before, and not after all the banks in the entire world implode into their own footprints of liability, and debt. Did they know, Boris? Or were they just stupid, and lacking in education? Given that they are culpable for the genocide of everyone in the world when the system crashes once and for all do you think that they knew this would manifest all along? Bottom line is that I, for one, think they knew this was a zero sum game all along.

A Pimp's love is different's picture

Jew counterfeit moneyprinters LOSING leveraged printed money account ledger entries???

 

UNPOSSIBLE!

MASTER OF UNIVERSE's picture

Zeros & ones are real enough to implode the entire system. Code is real and therefore it is logical to assume that the money involved in code is real as opposed to not.

Miles Ahead's picture

@Crash; not an economist obviously.  Me either.  But a bit less obviously so... (sniff)

The underlying ecomomy which is based on that "money" in digital, pulp, or nugget form, is. Entirely. 

If you don't believe it, stay tuned kid... 3,2,...

Yen Cross's picture

 

Don't tell that to MOe hOWARD...  She insists that all the interest on the Federal Reserve balance sheet is good for the serfs.

 

 Remember, " Chairsatan" twisted everything out to the long end of the curve???  Now that chicken is coming home to roost, as longer dated debt yields drop.

 

  LOL>>>  Snake meet Mongoose

toady's picture

What's a few trillion between friends? 

Yen Cross's picture

   ctrl-p >   It's a small club and we aren't invited.

  Love the </sarc> Toady.

Boris Alatovkrap's picture

Fallacy is that Central Bank is mission to "stimulate economy"... real mission is to preserve wealth of TPTB and create new opportunity to skim and capture profit through transactional extraction of wealth. This is not secret, is simple understanding of who is in control.

…but what is Boris know?

Yen Cross's picture

  You're a wise man Boris.  Additionally, you've conquered fractional reserve lending-- with flying colors.

 P.S. I love your Twitter posts. I don't have an account, but  really enjoy your feed.

 

aurum4040's picture

This is exactly why rates will never ever exceed 1% again period. Its this easy. Long AU

Excursionist's picture

But, but, but it's only mark-to-market losses.  If debt holders just hang tight until maturity, all will end well at par.

max2205's picture

Watch....the 1st trillionarie will be born out of the coming bond bust...who will it be?

nibiru's picture

What FED is doing is just a headline-porn. The tabloidization of political life already happened now we can see the same thing happening in the financial markets - think about the bigger picture and how this hike can affect all the debt which is accumulated by the US government?

 

Think what is more possible - rate hike or maybe NIRP - Janet already said that she doesn't rule out negative interest rates. http://independenttrader.org/was-the-last-euphoria-the-harbinger-of-rate-cut-and-qe-in-the-us.html

brada1013567's picture

Anyone who thinks that the Fed did not know, or even manufacture the Jobs number is an idiot. They never wanted to hike, the just needed a new excuse and viola now they have one.

chickadee's picture

The FED does not intend to book any losses by selling financial instruments. Even if they did, they can take infinite losses. No story here at all.

Tyler Durden's picture

This is not about the Fed

Yen Cross's picture

   I just think longer dated yields are going lower if the Fed. lifts rates. Yes the coupon value is higher, but yields for pensioners are destroyed.

  At some point, when faith erodes, then there's the distinct possibility, of the losses you mention.

  Investors price risk higher the further out they go, knowing this. I'd be more worried about the corporate bond and junk bond and MBS markets right now.

 It takes a trigger to set off the event you're speaking of.

 

Farmer Joe in Brooklyn's picture

I agree with Yen on this. I think initially the yield curve would trend toward inversion. Until complete faith is lost after the first major western sovereign default. Then kaboom!!

The Merovingian's picture

Absolutely correct. UST's are going to be the last turd down the bowl. Why do you think the debt of virtually every other sovereign is negative, whereas they all use to be way outside of us? This is a controlled fucking burn. The EU starts buying corporates next week. Then gues what, so does everyone else. The 10yr UST will be at or below 1% this time next year, perhaps sooner, and perhaps even lower ... like 0.50%. The curve is going to flatten and then invert while this happens, because they are going to raise rates at least once more (which will be the fucking catalyst). My guess is December, right after Trump wins. Then the market goes in the shitter, Obungler leaves Donny with a lit bag of shit on the front porch of a cleaned out White House, and riots start breaking out in wherever EBT cards are taken (because the system will snap ... pun intended.)

Buckle up kiddos, and make sure you have a couple weeks of food and water, and plenty of ammo, because this is going to be a Christmas like you've never seen before.

Trump 2016!

CorporateCongress's picture

You can still use the larger size estimate of 40trln as long as you also take into account the lower duration that goes with this aggregate size.

Saturn_ls1's picture

For short term - allowing banks, pension funds etc to price to book regulates the problem away.  For longer term can't the Fed continue buying tresuries at book value? QW - Quantative Washing?  The Chinese may not be happy but we live in interesting times?

XRAYD's picture

So, the rig the payroll numbers to manufacture an excuse ... to do nothing!

What will happen next month?  By golly, somewhere, somehow, there will be "something"!

 

thinkmoretalkless's picture

Yeah Jamie's got your back

SirBarksAlot's picture

Blah, blah, blah.

Who uses math anymore?

Sudden Debt's picture

Okay, America is fucked. So what's new?

Farmer Joe in Brooklyn's picture

I've been amazed watching the rally in banks (much to the detriment of my XLF puts). All the "smart crowd" in the media keep saying that banks will make much more in lending. 

But what they fail to grasp is the implosion in the credit markets that will result from another 50-100bps increase. The duration risk for fixed-income investors is just part of the equation. We will NEVER see 2% on the short-end again until after the reset. Oh, and don't forget about the stress that another 100bps will put on the real estate market.

The banks will be decimated by the default wave. But, then again, what does it matter when you have the taxpayers to bail them out..?

Delving Eye's picture

Correct, TD. As you say, the banks will always go for the quickest buck first. They'll look at the short-term profit to be gained by higher interest rates and, like a guy with a hard-on, lose the ability to think rationally because all the blood has rushed out of their brain and gone to the lower extremities -- where the money (honey) is. Screw whatever loss awaits in the long term.

ISawThatToo's picture
ISawThatToo (not verified) Jun 4, 2016 3:32 PM

"Why The Fed Is Trapped"

 

Yeah, "trapped" like rats in a full grain silo.

Contrariologist's picture
Contrariologist (not verified) Jun 4, 2016 3:38 PM

Can't keep doing what they are doing...and can't change and do something else. I love it.

We are screwed. Everyone, all together now: "We are so screwed, we are so screwed..." Keep chanting, a little louder now. Yes, I see that hand...praise the Lord, brother. Lift up your voices! "We are so screwed!"

ISawThatToo's picture
ISawThatToo (not verified) Contrariologist Jun 4, 2016 3:59 PM

The prepared are less-screwed.

The informed know who to screw back.

In.Sip.ient's picture

Sorry, I see no trap here for the FED.

I see a trap here if you hold their paper...

There IS a difference you know.

 

All the Treasury needs to do is the reverse of

what they did in the 1990s.

 

Extend the maturity of outstanding paper,by say 50 years,

and raise rates ( certainly by more than 1% !!! )... a lot.

Roughly stated , that $40T in outstanding paper

then trades for around $16T with a current 10% prime

rate.

 

What Debt Problem ... ;-)

 

 

MASTER OF UNIVERSE's picture

Who would buy it after they extended the maturity date to 50 years?

In.Sip.ient's picture

Sorry, I thought THAT was OBVIOUS!

The FEDs would.

 

Remember... if you owe yourself $40Trillion

what exactly do you owe???  And for them it gets

even better 'cuz they bought it for pennies

on the US$...

 

Baron von Bud's picture

The S&P500 has a pe of 18. It's 24 based on GAAP earnings. An unprecedented spread and very expensive by any measure. A 1% rise in short rates means a money market fund would yield 1.25%. Money would pour from stocks to tbills and likely set a stock crash in motion. With a flat yield curve money would pour from long bonds to short setting a bond crash in motion. Corporate yields would soar. So, Tylers, the losses would greatly exceed $1T. Que bono? Anyone fortunate enough to know the plan in advance and situated short in stocks or bonds like JPM and friends. Who would lose? Pension plans, insurance companies and other financial intermediaries holding money for the little people. Even a 50bp rise would do the trick.

falak pema's picture

FED is trapped and now being rapped by Saud's oil revolt and Russia's bolt into Syria...

It spells the decay of FED's iron grip on world petrodollar hegemony.

When a self fulfilling prophecy comes to fruition it is always to achieve the very end that it was formulated to conjure against.

--Caesar crossed the Rubicon...and thought he and progeny had won at Munda...

--The Popes created the Crusade that failed and whose fall-out led to their own decay.

--the Hindus created the cast system and thought it protected their heirarchy. It stultified them, like the Pyramid and religious cult of Amon culture ossified the ancient Egyptians.

-- The Jews thought they were the chosen race and got crucified by the Romans.

-- The French like the Germans lost it at Moscow.

-- The Americans have lost it since Nam took the Neo-cons to land of Apocalypse now militarism.

So the cycle repeats and every self fulfilling prophecy and mantra feeds its own decadence precisely because it is supposed to be "exceptional". Supreme irony of the Atreus tradition.

You go to Troy to win your civilization's Zeitgeist not to lose your all through Hubris; precisely when your Trojan horse trick has allowed you to burn your enemy to the ground.

Hubris is a disease that is the unintended result of greed beyond belief.

Self fulfilling like the FED today, its the noose to which you hang made of your own past criminal errors.

And the recurrence of crimes to defend the indefensible "big lie" of Hubris and "exceptionalism" casts a long shadow whose cover up is what starts the rot. Always true.

We never clean out the Augean stables, until its too late and the horses have bolted!

The reset starts once the war is lost and Ethics are the only way to clean out the past. Its called Renaissance.

MASTER OF UNIVERSE's picture

Always appreciate the historiography that you bring to discourse, falak pema, but once the war is lost we will be in thermonuclear winter, and I don't believe ethics can do much about that, frankly.

1980XLS's picture

These "assets" were created out of thin air and purchased with counterfeit money. Even a 50% loss is pure profit either way.

Kinda like bitching the store clerk shorted you on change, when you slipped him a phony bill for your purchase

JailBanksters's picture

You could sum it up with one phrase

You can't taper a Ponzi scheme.

Any body could make a profit if you could go down into the basement print off your own Monopoly Money then go shopping. As long as you can resell what you just bought is more than the Interest you have to pay the Club FED, your laughing all the way back to the Bank, quite litterally.

HerrDoktor's picture

Scram the son-of-a-bitch

g3h's picture

Can't really nake a valid point unless you also include assets in the picture.

As of end of 2015, U. S. had 80T in total net wealth, which meant total assets in excess of 120T.

So 40T in debt or other liabilities is not a complete picture.

 

But regardless, a loss in the event of rate increase is totally expected.  1T in loss out of total of 80T is not nothing, but small still.

Herdee's picture

The bottom line is only one thing.That's the enormous size of the U.S. deficit.They can't pay higher interest on it without going broke.The tax base won't support it.

Free_Spirit's picture

They'll just print it as long as they can do so without inflationary pressure. 

webdesignvalleys's picture

It is real cool when we can see the actual things like this. Like star wars move :D

Nobody For President's picture

What a bunch of nevous nellies, whinning about a lousy 2.4 trillion. The Fed can double seasonally adjust that bitch down to $14.67 and all is good.

Ink Pusher's picture

The FED is floundering. The Petro-Dollar is gasping and everyone is waiting for Yellen's "tone". Really ? What the fuck?  They might as well be betting the spread on daily weather changes in Cucamonga. The corner they painted themselves into with all that thermite is going to ignite and burn down the whole farm. 

Yellen's got no choice but to play the Dovish Card and keep dumping billions in paper to prop the gasping greenback up. If she doesn't gold will go ballistic and shtf day for the markets will be immediate and brutal.