Drawings of the economy: the inverted rate curve and the fall of Silicon Valley Bank

Drawings of the economy: the inverted rate curve and the fall of Silicon Valley Bank

An important question in relation to financial markets is what the interest rates at which it is possible to lend or borrow money in an economy depend on. Among many other factors (such as the risk of insolvency of the borrower, liquidity, monetary policy, the economic cycle…) it is worth highlighting the term of the loan operation.

Short rates and long-term rates

In the case of bonds and other fixed-income financial assets, which are nothing more than securities representing the aliquot part of a loan, it is obvious that the interest rate or profitability offered by said securities will depend on their term. until redemption, even if the issuer of the securities (the borrower) is the same. Thus, in the public debt market we can see that the interest rates at which bonds and debentures are being traded are different depending on their term.

Here are represented the returns offered by government bonds and obligations based on their term on July 18, 2022, just before the start of the path of interest rate increases by the ECB. It is a photograph of the Spanish public debt market on a specific day, and in which the horizontal axis represents the term of the bonds and obligations.

In this graph we can see what we could call the normal situation: long-term interest rates are higher than short-term interest rates. Note how short-term rates depend fundamentally on the official interest rates set by the ECB, which in July of last year were still below zero.

On the other hand, it must be taken into account that, according to certain hypotheses, longer-term interest rates reflect expectations about the future behavior of short-term interest rates. In this way, we can see how medium and long-term interest rates have already advanced the interest rate hikes announced some time ago by the ECB.

What has been the shape of the yield curve of late?

However, we can also observe that the shape of the relationship between the interest rate and the term changes over time. For example, as of March 9, 2023, the market situation is shown in the following figure:

As can be seen, the curve has gone from having a positive slope to being practically flat; short-term rates have already included the interest rate hikes carried out by the ECB in recent months.

In any case, there continues to be a curve with a certain positive relationship between interest rates and term.

However, it is also possible (counterintuitively) that short-term rates are higher than long-term interest rates. And this is precisely the current situation of the US public debt market. We have collected the difference between the 10-year interest rates and the three-month interest rates of the US market:

When this differential is below zero, it indicates that long-term interest rates (10 years) are lower than short-term interest rates (3 months).

Why is this situation worrying? Because, at least in the United States, it often precedes economic downturns. As pointed The Economist in 2019, in the eight recessions since 1960, three-month interest rates have been higher than ten-year interest rates for at least one day during the previous year. This signal has only produced a false alarm.

If we look at US quarterly GDP over the last five years, the inverted curve seems to have anticipated the critical situation experienced by the pandemic, but not the recession suffered last year, when US GDP fell for two consecutive quarters.

Why does the yield curve invert?

The reasons put forward in relation to the predictive power of interest rates (although there is no widely accepted explanation in this regard) are various and logically have to do with the expectations of economic agents.

On the one hand, rate hikes by central banks (in this case the Federal Reserve) cause short-term rates to rise, but this can cause a recession and the need to lower them at a future date (which is which advance longer-term interest rates to below short-term rates).

On the other hand, there are those who argue that, in situations of uncertainty, investors want to hedge their risks by guaranteeing a stable income and, therefore, given the prospect of a crisis, the demand for safe long-term bonds increases, increasing their price and, therefore, therefore, causing its profitability to fall (remember that there is an inverse relationship between the price of a bond and the profitability it offers).

Effects on the US economy

For now, what we have been able to observe in the US has not only been an inversion of the curve, but also a general rise in interest rates both short and long term.

In fact, ten-year interest rates rose from 0.6% in April 2020 to almost 4% at the beginning of March 2023. It is precisely this rise in long-term interest rates that seems to be behind bankruptcy of the american bank Silicon Valley Bank (SVB).

We have already seen that increases in interest rates cause decreases in the value of bonds and obligations, especially in titles with long-term maturities. For example, a 1% rise in the interest rate can cause a fall of close to 10% in the value of a ten-year bond, including government bonds. In the United States, the rise has been around 2% in the last 12 months alone.

a wrong strategy

In the case of the SVB, a US bank specializing in financing start-ups and high-growth companies, significant resources were invested in financing their clients with long-term bonds, so the rise in long-term rates caused significant losses in the value of their assets.

The bank tried to mitigate these losses through, among other things, a capital increase, also forced by the change in the bank’s valuation perspective by the rating agencies. rating.

All of this could have been the starting signal for the massive withdrawal of deposits. Hence the need for the SVB to obtain immediate liquidity, for which it resorted to the sale of assets (which caused additional losses). From there, we have the classic example of how liquidity problems end up becoming a solvency problem.

What is surprising is that in the a e i o u of bank management, one of the main points to consider is the correct management of assets and liabilities (ie, the sensitivity of assets and liabilities to changes in interest rates), something for which there are numerous instruments.

Data is still lacking but it would be surprising that the bankruptcy of the SVB could have been due to this issue, which raises questions regarding the role of the bank’s managers, the supervisory body and even the credit agencies. rating.

The immediate question is whether these management problems detected in the United States, and the consequent drop in confidence in the financial sector, can be transferred to the rest of the world.

Eliseo Navarro ArribasUniversity Professor of Financial Economics, University of Alcala; Carlos Esparcia SanchisPhD Assistant Professor, Financial Economics Area, Department of Economic Analysis and Finance, Castilla-La Mancha university and Francisco Jareno CebrianUniversity Professor, Area of ​​Financial Economics, Department of Economic Analysis and Finance, Castilla-La Mancha university

This article was originally published on The Conversation. read the original.

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