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Good morning. Iran indicated yesterday that vessels deemed “non-hostile” could traverse the Strait of Hormuz, provided Tehran’s approval. Should this evolve into a viable provisional arrangement permitting petroleum transit from the Gulf, financial markets are likely to react. For now, however, it appears to be a very preliminary move. Reach us via email: [email protected].
Long-duration interest rates
Short-term government debt yields have markedly increased since the conflict began, as investors foresee fewer central bank rate reductions or even rate hikes. That fiscal rationale is quite evident. Nonetheless, the extended end of the yield curve has also climbed significantly, and the reasoning behind this is more intricate. The upward movement in the long end isn’t being driven by anticipated long-run inflation; it’s almost entirely due to real interest rates, as indicated by inflation-protected yields. Presented here are 30-year US real rates and break-even inflation:
The identical chart for 10 years is shown below:
Why might the conflict in Iran and the ensuing energy predicament produce this outcome (assuming the conflict is indeed the underlying cause)? A straightforward explanation is that the term premium — the additional return investors gain for holding long-maturity bonds — is rising beyond the projected trajectory of short-term interest rates. This phenomenon can be interpreted in several ways. It might be that investors are demanding a greater yield for owning long bonds because they anticipate higher inflation variability in the future. The elevated real rates serve as a safeguard. Alternatively, in an environment prone to more inflationary occurrences, bonds might become less effective as a diversifier for equities; meaning, they are more prone to decline concurrently with stocks. Consequently, investors necessitate a higher return to possess them. Dario Perkins from TS Lombard holds this perspective:
The term premium . . . has begun to climb. This is logical — supply disruptions harm economic growth and increase inflation, which diminishes the protective attributes of bonds. The term premium functions, in essence, as an insurance premium. People include bonds in a portfolio specifically for their hedging capabilities.
However, as Ed Al-Hussainy of Columbia Threadneedle highlighted to me, this presents a certain enigma. If investors are foreseeing reduced growth and amplified inflation, shouldn’t they be divesting from risk assets? Indeed, stock values have decreased by roughly 5 percent and credit spreads have widened somewhat since the onset of the conflict. Yet, from a broader view, we remain near all-time peak levels/tightness.
Another potential scenario is that geopolitical turmoil introduces uncertainty into markets, and the long end of the curve has simply become excessively undervalued. An energy crisis can simultaneously boost inflation (unfavorable for bonds) and impede growth (beneficial). It might be that investors have become overly concentrated on the former effect and have overlooked the latter. If this resonates with you, you understand the appropriate course of action.
(Armstrong)
US banking regulations
Last week, the three primary US banking oversight bodies — the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency — unveiled much-discussed proposals intended to ease restrictions for major financial institutions. Depending on the interlocutor, these adjustments are either a necessary modernization (as per the Fed’s description) or perilous deregulation (according to skeptics). Numerous technical specifics exist for debate, but the overarching direction is quite apparent.
Subsequent to the 2008 global financial downturn, bank capital requirements were elevated. Most individuals concur that this was a sound measure; nevertheless, some believe an overcorrection occurred. An authority with intimate knowledge of the subject conveyed it to us in these terms:
These modifications do not represent a complete reduction or a significant philosophical shift. It is reasonable to implement some fine-tuning around the edges — we essentially employed a crude instrument in 2010 by merely attempting to inject more capital into the system . . . It is not socially desirable to engineer a system utterly devoid of crises, as that would effectively eliminate financial intermediation . . . We undoubtedly relinquished some economic expansion.
Two prominent areas of focus stand out to us: mortgage lending and the capital adequacy requirements for large banks. A consequence of the regulatory framework/overcorrection following the GFC has been the substantial entry of private credit providers and hedge funds into lending markets. Michelle Bowman, a Fed governor and vice-chair for supervision, who has championed these proposals, has highlighted that bank-initiated mortgages have declined to approximately 35 percent of the total in 2023 from 60 percent in 2008. Her objective is to reverse this pattern. Two of the proposals aim to eliminate the deduction for mortgage servicing assets from the calculation of the highest-quality bank capital, Common Equity Tier 1 (CET1), opting instead to assign a fixed 250 percent risk weighting to encourage banks to engage more in mortgage servicing.
The proposals also introduce revisions to the Basel III “endgame” reforms, which pertain to the largest banks (Global Systemically Important Banks, or “GSIBs”) and other substantial financial entities. This represents a far less rigorous interpretation of Basel III than what Michael Barr, then the vice-chair for supervision at the Fed, put forth in 2023. The modifications being suggested include a unified framework for risk-based capital requirements, replacing the current dual system approach that permits the use of internal models. Furthermore, there are adjustments to the risk framework for trading departments, encompassing a narrowing of the scope of banks subject to Basel III by elevating the applicability threshold to at least $5bn in trading volume from $1bn.
The Fed estimates that the various proposals it released, alongside the alterations to the supplementary leverage ratio and stress tests that have already been enacted, would lead to a reduction in CET1 levels by about 5 percent for the largest banks.
Such a change would not seem to precipitate another financial crisis. Nevertheless, not everyone is convinced of the merits of these proposals. Phillip Basil of Better Markets expresses skepticism regarding whether this will genuinely motivate banks to participate in lending to the “actual economy,” which he contends is primarily driven by community banks, rather than fostering greater consolidation among large banks and an expansion of market trading activities.
Barr was the sole dissenting voter on the Fed board concerning all three proposals, contending that they, combined with the relaxing
pertaining to stress testing and SLR, contradict the core tenets of the Basel III amendments:
A primary objective of the Basel III changes was to rectify the insufficient capitalisation concerning market-related perils . . . The Basel III agreement was crafted to bolster banks’ capacity to endure dangers stemming from their market dealings, thereby safeguarding against a future financial upheaval. However, the equity mandates for these operations are now being substantially lowered . . . The banking sector is fundamentally founded upon confidence. I am deeply concerned that these measures are swiftly diminishing that confidence. I object.
Unhedged opines that some easing of guidelines is suitable, provided it is not paralleled by a similar dilution of financial oversight. Regulations lacking effective and rigorous implementation amount to nothing more than textual declarations. Personnel and assets have been cut back throughout the national oversight bodies. Should that transpire within the banking sector, we would be courting a further downturn.
(Kim)
A Noteworthy Article
Concurrently, this situation is persisting.
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