Thursday, 11 June 2009

Financial stability vs. cost of debt

Ten year government bonds are hitting highs in the UK and the US - strangely enough, 4% is the magic number in both countries.

Is this good? Clearly increasing yields make it more expensive to raise debt, and both governments have big deficits to service. So rising yields is a bad thing.

But... bank net interest income depends quite sensitively on the shape of the yield curve. If the curve is sharply upward pointing, as it is at the moment, then banks who borrow short and lend long make more money. Profitable banks rebuild capital fast. So rising ten year yields are actually good for financial stability at the moment.

The time for the curve steepeners may well be ending, though. This trade has given most of the juice it has, in my judgement. It might even be time to go short credit for the first time this year...

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2 Comments:

Blogger Dave said...

Does borrowing short and lending long create genuine shareholder value or is it just a spurious accounting profit?

If the 10 year rate, say, reflects the expected average overnight rate over the next 10 years (I know that there is a duration premium, but bear with me), then there will be no expected profit over the 10 year period. "Profits" at the start of the term will be offset by expected "losses" over the remainder.

So, is this just the start of another banking cycle, where "profitable" banks will come crashing down in 10 years time?

12:17 am  
Blogger David Murphy said...

Tricky one. On average the yield curve points up, so on average taking funding liquidity risk makes money for shareholders - on average the Libor in the future isn't as high as the curve said it would be.

However, the fact that this risk is invisibile under accrual, together with the fact that it attracts no capital, does make it a hidden risk. Everyone (more or less) is the same way round, too. The way to fix this is simple: require capital against all interest rate risk, not just that in the trading book.

6:08 am  

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