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Liquidity Crisis II: The Revenge of Discounting Interest


1 October 2022


 
The End of Currency (Permanent Liquidity)
The End of Currency (Permanent Liquidity)
 


It sounds like a sequel to a thriller. Indeed, the thriller is Do central banks set interest rates, or do markets? And it was written just a week ago. It tells that central banks signal their intentions to financial markets. That allows financial institutions to trade government bonds at a profit. For instance, if the central bank intends to change interest rates, it gives advance notice so financial institutions are not caught off-guard and can adapt their bond portfolios and borrowing.

That is a subsidy to the financial sector. We all pay for banking profits in this way. It is how financial institutions operate under the present conditions. Free markets would cause mayhem because of greed and fear while eliminating the profit motive could promote uneconomical investments as happened in socialist economies. One advantage of Natural Money could be the end of this subsidy. But don't cheer yet. You may have to pay more for the services of your bank once it is weened off these easy profits.

The issue became at the centre of a drama that played out during the last week. The bond markets of the United Kingdom went into disarray because interest rates spiked after the government announced a massive spending package. It suddenly became clear that the Bank of England might have to raise interest much further than previously thought to contain inflation. Financial institutions were caught off-guard. The Bank of England had to intervene in the bond market to bring down interest rates.

Financial institutions borrow short-term money at the central bank and invest it in the bond market. To borrow this money, financial institutions pledge these bonds as collateral, just like your house is the collateral for your mortgage. If interest rates rise, the value of the bonds drops because of discounting. You can read more about it in blog post Shadows grow taller until the sun set. So, if financial institutions borrow 90% of their investment, and the value of the bonds drop 10%, their equity is wiped out.

That is a scary thought. A UK bond trader noted, 'If there was no intervention today, gilt yields [yields on UK government bonds] could have gone up to 7-8 per cent from 4.5 per cent this morning and in that situation around 90 per cent of UK pension funds would have run out of collateral... They would have been wiped out.'1 The trader implies that pension funds are also borrowing short-term to invest long-term in the bond market. In other words, they do a trade banks usually do.

It is a sign of the times. In the past, pension funds invested in bonds for the long-term, but bond yields were low in the past decade because interest rates were low. Pension funds have fixed obligations in terms of money, for instance, paying a retiree € 1,000 per month until he dies. If interest rates go down, you have to pay more in pension premium to arrive at that amount, because the money in the pension fund grows more slowly.

A calculation can illustrate this. Assume that an employee puts € 1,000 in his pension fund at the age of 20, and retires at the age of 65. If the interest rate is 10%, the € 1,000 has turned into € 72,890 after 45 years. That covers six years of pension payments. If he pays an additional € 1,000 in the next two years, it would probably cover his entire pension. But if the interest rate is 1%, he will be paying € 3,800 each year for the rest of his working life to arrive at the same amount.

No one wants to pay more, so pension funds started to invest in the stock market because the average return on the stock market has been around 10%. And they began to participate in the trade of banks, which is borrowing money at the central bank and invest it in the bond market. If you use leverage in this way, you can turbo-charge your profits. An example can explain it.

Suppose that the interest rate on 10-year government bonds is 3%, and you can borrow money at the central bank at 1%. Then you can do the following math:

  • If you invest € 1,000,000 in the bond market, you can make € 30,000 per year or 3% on your investment of € 1,000,000.
  • If you invest € 1,000,000 in the bond market and borrow another € 1,000,000 at the central bank, you receive € 60,000 in interest and pay € 10,000 in interest, so you make € 50,000 per year or 5% on your investment of € 1,000,000.
  • If you invest € 1,000,000 in the bond market and borrow another € 9,000,000 at the central bank, you receive € 300,000 in interest and pay € 90,000 in interest, so you make € 210,000 per year or 21% on your investment of € 1,000,000.

  • That sounds great, but here is the catch. If you have invested € 1,000 in 10-year bonds, and the interest rate on these bonds suddenly rises to 6%, their value will drop to € 779,19. In other words, the loss is 22%. Blog post Shadows grow taller until the sun set explains how you can do the calculation, but it easier to use a calculator like BuyUpside - Bond Present Value Calculator that does the hard work for you.

    That may sound dramatic already, but if you have borrowed money to invest in the bond market, it becomes a lot scarier because you just have turbo-charged your losses. So, let's do the calculations:

  • If you have invested € 1,000,000 in the bond market, your loss is € 220,810, or 22% on your investment of € 1,000,000. You are left with € 779,190.
  • If you have invested € 1,000,000 and borrowed another € 1,000,000, your loss is € 441,620, or 44% on your investment of € 1,000,000. You are left with € 558,380.
  • If you have invested € 1,000,000 and borrow another € 9,000,000, your loss is € 2,208,100, or 221% on your investment of € 1,000,000. In other words, your investment is wiped out and you are left with a debt of € 1,208,100.

  • The idea of high interest rates is flawed. Pension funds often worked with an interest rate assumption, for instance, 4%. But you cannot expect 4% returns in the long run if the economy grows at 2%. These are promises you probably cannot keep. But no one wants to tell employees that they have to pay more for their pensions. They will probably find out that they will receive less than expected when they retire, and perhaps sooner when their pension funds face losses from these risky trades.

    With Natural Money, central banks usually do not lend money to banks or pension funds. They have to find their funding in the financial markets. That should not be a problem because the holding fee on currency is 12%. If a financial institution is solvent but short of cash, and needs to pay another financial institution, it can borrow currency at the central bank at zero interest, and pay the other financial institution in legal tender yielding -12%. And so, it will accept a bond as payment or collateral for a loan.

    You can read more about that in blog post Permanent Liquidity.

    1. UK Pensions Got Margin Calls, Matt Levine, Bloomberg.com, 29 september 2022.