Rising Global Recession Odds Signal More Credit And Market Risks For Financial Institutions

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Risk managers will struggle with an impending global recession.

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Financial institution risk managers, regulators and legislators should intensify their focus on macroeconomic and market data that are signaling rising odds of a global recession. Today’s 10-year U.S. treasury falling significantly to 1.59% and below the equivalent rate for the U.S. 2-year treasury bond, for the first time since 2007, is an ominous sign for the U.S. economy. Financial institutions, especially, are incredibly sensitive to interest rate signals. This inverted yield curve, while not guaranteed, signals that we might soon enter a recession.

10-Year U.S. Treasury Rate

Macrotrends

Even before today’s curve inversion, the Federal Reserve’s recession probability model was already showing a 31.5% chance of a recession in the next 12 months; this recession probability is slightly higher than it was in July 2007.

Probability of US Recession Predicted by Treasury Spread*

Note: Twelve Months Ahead (month averages) Source: Federal Reserve Bank of New York Recession Probability Model

What is equally disconcerting is how low the 30-year yield is as well. The 30-year yield of 2.015%  is now at the lowest level it has been since June 2016 when the British voted to leave the European Union. I fear that a 2-year treasury bond will soon yield more than the 30-year one.

30-year U.S. Treasury Rate

Macrotrends

Unfortunately, it is not only the U.S. that has an inverted yield curve. The UK 10-year gilt yield fell below the 2-year gilt the first time since 2008.  Two days ago, the German yield curve which is negative, had the 10-year German bund yielding less than a 3-month Germany treasury.

The rising odds of a global recession means that risk managers need to do more to measure their credit, market, operational, and liquidity risks in order to recalibrate their risk models.  The model results should lead risk managers to focus on what assets to sell to reduce risks, enhancing internal controls, and likely changing derivatives positions that mitigate credit and market risks.

What should worry risk managers is that we are in unchartered territory.  According to Sven Henrich, founder and lead market strategist for NorthmanTrader, “We’ve never faced a recession with so much debt and so little Fed ammunition available.” I agree with him that “With negative rates still in effect in many places, there’s no playbook for this. Historical data will be of little use.”

Sven Henrich

Northman Trader

Rising repurchasing (repo) market rates seem to concur with Henrich; market participants are indeed worried that the U.S. treasury will continue to issue more debt to fund expanding deficits.

Repo Rate for Treasurys and the Fed’s Interest on Excess Reserves

Factset

Lower rates in most of the key economies in the world will certainly put earnings pressures on financial institutions both in their loan and securities portfolios. Moreover, low interest rates and possible decreasing rates in some emerging markets and in the U.S. means that more companies are likely to borrow even more money. In the U.S. corporate debt is at about 75% of GDP, and a rising amount of that debt is in the form of below investment grade bonds or covenant-lite and document-lite leveraged loans.  Given how indebted companies are already, an economic downturn will increase the likelihood that companies will fire people in order to cut costs and service debt and will push up the probability of corporate default. Corporate debt is held widely all around the world by a diversity of financial institutions, especially banks, securities firms, pension funds, and insurance companies.

The rising odds of a recession also means that financial institutions should increase their capital buffers to help them sustain unexpected losses. Banks, pension funds, and insurance companies have regulatory or legal requirements that will make them more attune capital deteriorating; non-banks tend to have lighter requirements so they could present a bigger challenge to the safety and soundness of the financial system. This certainly is not the time to weaken any kind of financial institutions regulations and oversight, and the non-banks certainly need more attention from legislators and regulators.

 

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