Chances rise for a financial crisis in the next 12-18 months

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Interest rate volatility sets the stage for the financial crisis

If you listen to the Federal Reserve and the mainstream financial press, you might be convinced that everything is under control in the stock market and the economy. Unfortunately, here’s the reality: the likelihood of a financial crisis occurring in the next 12 to 18 months could be at its highest level since the 2008-2009 financial crisis.

A financial crisis occurs when asset prices fall, the financial system becomes severely stressed, and panic reigns. Investors beware: Massive losses could be ahead.

There is one important factor that investors really need to consider: the volatility of the interest rate market.

See table below; it plots the yield on 10-year US Treasury bonds. This yield is a benchmark interest rate for many things, including mortgages, auto loans, and how banks lend to each other. If the yield on these bonds fluctuates, interest rates at all levels will fluctuate.

Graphic courtesy of StockCharts.com

Over the past year, the yield on 10-year US Treasuries has climbed almost 100%. Since the time of the COVID-19 pandemic, the yield on these bonds has increased by almost 170%. In other words, interest rates have been extremely volatile.

The problem: too much debt

The US economy is extremely indebted right now.

US consumer debt in the first quarter of 2022 fell from $266.0 billion to $15.8 trillion. The consumer debt balance is now $1.7 trillion higher than it was in 2019, just before the pandemic. (Source: “Household debt and credit reportFederal Reserve Bank of New York, last accessed June 8, 2022.)

Thanks to the low interest rates of the past few years, American businesses have also become dependent on debt. At the end of 2021, outstanding corporate bonds in the United States stood at just over $10 trillion. At the end of 2019, it stood at $8.9 trillion. (Source: “US corporate bonds: issuance, trading volume, outstanding”, Securities Industry and Financial Markets Association, last accessed June 8, 2022.)

Moreover, the US government borrowed money without remorse. The US national debt stands at $30.4 trillion. (Source: “Debt to Penny», US Treasury, last accessed June 6, 2022.)

In the years to come, there is absolutely no budget surplus in sight. This means that the national debt could be much higher than it is now.

The financial sector has also taken crazy measures. At the end of 2021, it had derivatives with a notional value of $177.5 trillion. Here’s the kicker: 71.1% of these derivatives were linked to interest rate related products. (Source: “Banks’ Trading and Derivatives Quarterly Report: Fourth Quarter 2021(Office of the Comptroller of the Currency, last accessed June 8, 2022.)

With so much debt and so many derivatives, could anything go wrong?

Dear reader, I don’t like to be the bearer of bad news. I like when everyone makes money. However, I don’t like putting my head in the sand and pretending that everything is fine when it’s not.

There is a lot of volatility in the interest rate market and there is a lot of debt and interest rate derivatives. As such, I think it’s likely something is wrong. The dollar amount behind interest rate derivatives is so high that if just 5-10% of derivatives in circulation move in the wrong direction, we could see a bank collapse in no time.

The financial crisis of 2008-2009 was triggered by a high amount of debt and derivatives. If another financial crisis were to become a reality, an immense amount of misery could ensue.

The market typically bottoms out in the midst of a financial crisis at 10 to 15 year lows, not two to five year lows. There could be significant losses on various assets, so a lot of caution might be needed.

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