A slog special





Size of interest rate derivatives sector the key


Disturbing events have been gathering pace over the last few days – signs that suggest Crash 2 may be imminent. In particular,  central banks seem almost suicidally keen to maintain zero interest rates, and persevere with QE….when neither policy seems to be delivering a discernible benefit.

On the basis of that behaviour, a radical analysis is gaining ground on both sides of the Atlantic . This is that our governments now have a straight choice to make: save the banks, or save society’s most basic expectations of  life-quality.  In this special analysis, The Slog suggests that Bernanke, King and Trichet could well have opted to save the banks.


An alarmist opening perhaps, but as Sherlock Holmes famously remarked, “Once every other likelihood has been explored, what remains is the truth – no matter how unlikely”.

Just under three weeks ago, The Slog posted at some length about the 30-year US bond yield, and the so-called ‘5% signal’. Today the yield has stopped edging upwards and moved sideways, but this didn’t deter a senior American analyst source from opining as follows just after 1pm GMT today:

“Bernanke no longer has a grip on the 30-year rate,” the source told The Slog, “and that means he’s trying to save something he thinks is even more important than that. Frankly, that something is the banking system”.


Let’s rewind the tape for newer readers. Long (15yrs+) US bond yields reflect the degree of trust in the States as an investment. The higher they go, the more people think long debt is risky. Last October, the US rates were 3.3%. As I write, they’re 4.68%. 5% is generally regarded as a danger signal – a flashing red light that says, in a stock market topping out, ‘let’s get out of stocks and into bonds’.

One way among many to reduce yields (and keep the stock market safe) is to raise interest rates. This increases the Dollar’s value, and settles the debt markets down. The assumption by many thus far has been that – to give the real US economy the best chance – the Fed has been weighing in with zero rates and QE in order to stimulate that economy.

Very much the same applies to Britain’s Mervyn King. But from the start of zero rates, The Slog argued vociferously that they’d make no difference to the economy, as the demand from nervous consumers and business wasn’t there for loans in the first place. Further, on neither side of the Atlantic has QE achieved anything of substance for economic growth.

This extract from a recent article by respected US economic commentator Charles Hugh Smith is instructive:

‘Here is where we are in a nutshell. The general populace has seen its income decline as the Fed’s ZIRP policy has channeled their interest income directly into the banks, and as their wages stagnate. Yet thanks to the speculative inflation engineered by the Fed, prices are rising. In an organic inflation, wages and interest income would both be rising along with prices. So the direct result of the Fed’s policies is higher costs and the transfer of national income to the banks…’

This is Smith’s closing emphasis, not mine. It accords directly with the view of the UK’s Full Circle boss John Robson. But the question remains: unless you were some piece of social engineering anti-matter, why on earth would you do this?

I wrote last year – and repeat now – that so-called ‘zirp’ was a way to enable banks to earn effortless profits and thus repair the enormous damage self-inflicted between 2002 and 2008. But why keep on doing it?
Last week, another UK-based wealth manager made this cryptic remark as we met over a drink:

“Watch what Merv does if the inflation figures are bad. If he argues for doing nothing just yet, then I’d say his game-plan is clear, and he’s in the same boat as Bernanke”.

Today has seen exactly that reaction from BoE Governor Mervyn King. He is indeed in the same leaky boat as Ben Bernanke – and the leak in the boat is called the interest rate derivatives market.

They may be in the same boat, but they’re not using the same bailing equipment. Bernanke is persevering with QE because he has the money, whereas King and the UK Treasury don’t. So Merv’s frontline weapon has to be the only one he’s got: zirp for as long as possible.


QE is the process by which the Fed (that is, you and I) buy bad banking bets back off them. The main bad bet in a rising interest rate market would be….interest rate derivative bets.

Zirp is the process by which the normal market for rates is kept low. Doing this keeps (for a time) bad bets potentially good in the…..interest rate derivatives sector.


Pause again to take this in, because it makes my head spin too. Why is the interest rate derivatives market important?

The answer is that some banks have made silly bets about rate movements. It would only take between 3 and 10% of those bets to be way off to give us a problem far bigger than 2008.

Here’s why. The 2008 mess (‘Crash 1’) was caused by another derivatives sector – the one for credit default swaps. All up, that sector was never bigger than $55 trillion in size – and at the time of the crash, only about $37 trillion. Even at only 7.8% of the derivatives market, CDSs took down Bear Stearns and Lehman.

Today, the interest-rate derivatives swap sector is worth $342 trillion. It is, by miles, the biggest market in the world.

The total global economy is around $58 trillion. And given that the Global worth of all the bourses everywhere is only $36 trillion, you can see why, if only a small number of bets were dumb, then it’s all over this time around. Not even the US has the debt credibility any more to bail that scenario out.

And as we’ve all learned to our cost in recent years, most bankers are arrogantly, recklessly dumb. Not only that, the signs are that not just a few bets have gone awry: both banks and multinationals are hooked into low-rate bets bigtime.

Equally worrying is that it’s the long-term banking firm ‘winners’ – the usual list of suspects – who have driven up this market to its current insanely engorged size. The biggest sellers of rate derivatives are Barclays, Deutsche Bank, Goldman Sachs and JP Morgan.

According to the Bank for International Settlements, the U.S. interest rate swap market has nearly doubled in size in the past two years. The famous financial site Washington Blog writes about ‘the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates’ and concludes that ‘the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely’.

American banks aren’t the only ones: our feckless friends here in the UK are up to their eyes in it too. Thus one begins to grasp why Merv is putting off the evil rate rise moment.


These last few days, I’ve also been checking with some European contacts about this scenario. Most said that having derivative sectors bigger than ‘real’ markets would always be an inherent and unreformed threat to global financing. Interesting was this quote from a German trader:

“I would say that this is one of the main drivers behind the EU being in such a hurry to get minimum capitalisations up to at least 10%. It is one of the few wise things Brussels and the ECB have lobbied for. It also explains why Deutschebank bought Deutschepost…to provide quickly the capital required to reach a healthy ratio. So yes, on the whole I would say that the scenario is one everyone fears.”


Whatever explanations investment bankers come up with, they tend to come in three forms, and in this order:

* We know exactly what we’re doing, now shut up and mind your own business.

* If you don’t give us $5 trillion by this time tomorrow, the planet will explode, and all human life will be vapourised.

* None of what happened was our fault, and anyway you can’t do without us – so leave our bonuses alone or we’ll all leave.

But ever since studying German inflation for a University dissertation over forty years ago, I have taken this lesson with me through life: economic depressions and banking failures make things very tough for business, but hyperinflation destroys the fabric of society utterly.

So whatever the downsides of Crash 2, they could not be as bad as double or even treble digit inflation.

Today, the BoE projected inflation by the Autumn at 5%. Both their last two forecasts have been wrong. Even if the current rate of inflation increase held steady, my maths say that by October, 11% is a more likely figure. Earlier this week – as The Slog revealed yesterday – MIT calculated the US annualised inflation rate to be 17.3%.

Now if the ultimate aim of Fed, BoE and ECB policy is the stimulation of recovery without too much inflation, then we have precious little to worry about. Sure, there will be suffering – especially among the poor. But our institutions and liberties will survive.

However, if the foregoing analysis – and the measured opinions I’ve heard – are even 75% on the money, then the key Western CBs may well have chosen the bank-saving option….even though that appears an impossible task.

In private, Mervyn King is excessively rude about investment bank risk-takers. As he stated again today, he feels genuine sympathy for innocent people on modest incomes taking the hit for egomaniacs like Fred Goodwin and Bob Diamond. And he has said repeatedly that nowhere near enough reform has been undertaken since 2008.

Both Basel’s regulators and Jean-Claude Trichet have echoed this – Trichet even more forcefully. In private, I understand he too has said that a figure of 15-20% liquidity to capital is what ‘responsible’ banks should be aiming for.

Finally, in his book Whoops! John Lanchester maintained that derivative trading remains the biggest danger to banking solvency: there is nothing, he believes, to stop another set of loopy bets taking the system down.

But there is one other crucial observation Lanchester makes, and it is this: even central bankers get themselves into a mindset that sees global banking collapse as the ultimate act of human self-annihilation. Like The Slog, he is still waiting for a convincing answer from the investment banking industry as to why they should take such a crazy idea seriously; but here’s the bottom line: themselves caught in the fnancial bubble, it is conceivable that the avoidance of such an outcome seems more important to the Kings, Bernankes and Trichets of this world than the control of rampant, speculative inflation.

We must hope not. But we must keep a close eye on events as they unfold.


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