Has The Derivatives Volcano Already Begun To Erupt?
by David Goldman via The Asia Times,
ZeroHedge.com
Wed, 10/10/2018
The cure for the last crisis always turns into the cause of the next one…
The economies of southern Europe – Greece, Italy, Spain and Portugal – nearly collapsed in 2011, and Europe’s monetary authorities responded with negative interest rates. So did Japan.
Europeans and Japanese pay to hold cash or own 10-year German government bonds, which means that every pension fund and insurer will fold in a finite time horizon. They responded by exporting more, saving more, and buying American assets that still pay a positive, if low, real yield.
Hedging the foreign exchange risk in this half-trillion-dollar per year business has exhausted the balance sheet of the global banking system. That explains a large part of the jump in the US 10-year note yield to 3.2% last Friday from 2.85% in early September. Hedging the foreign exchange risk in these massive flows created a derivatives mountain, and it has started to spew smoke and lava.
Banks are rationing foreign-exchange swap lines, making hedges so expensive that German and Japanese investors can no longer afford to buy US bonds. If the foreign bid for US debt dries up, the cost of financing America’s $1 trillion annual budget deficit will rise, and so will interest costs around the world.
The mechanics of hedging trillions of dollars of capital flows are complex, but the economics are simple. Germany and Japan together export half a trillion dollars a year of goods and services more than they import. America imports more than half a trillion dollars of goods and services more than it exports.
Germany and Japan have negative real interest rates, so their investors buy American bonds at positive real interest rates. But Germans and Japanese have to pay out Euros and yen, not dollars. They go to their banks to swap dollar income into local-currency income. The banks borrow dollars in the United States, sell them in the forward market and receive Euros and yen.
European banks are running out of borrowing capacity. After five years of negative short-term rates, their profitability is low, their stock prices are falling and their credit is deteriorating. They can no longer borrow the dollars required to construct the hedges that local investors need.
Foreign exchange derivatives form the biggest mountain of obligations in the world financial system – a notional amount of about $90 trillion, up from $60 trillion in 2010. Breaking down the numbers, Bank for International Settlements (BIS) economists showed that the foreign exchange derivatives taken on by non-financial corporations tracked the growth of world trade, and the derivative obligations of nonbank financial institutions – money managers and insurance companies – tracked international securities investments (see chart below).
The Rest…HERE
