Has the derivatives volcano already begun to erupt?

Has the derivatives volcano already begun to erupt? By David Goldman.

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.

This pushes down interest rates in the US (pushes up bond prices). But lately their appetite for US bonds has waned, and US interest rates are rising. This makes funding more expensive for the many countries that have to borrow dollars to cover deficits — including the US and Australia.

The more complex and scary stuff:

For more than one year, international bank regulators and the International Monetary Fund have warned that the banking system no longer can support these enormous flows. The Federal Reserve is tightening liquidity in the US, and in a volatile market, European banks might not be able to roll over nearly $11 trillion of short-term obligations – and might default.

As the BIS warned in September 2017: The combination of balance sheet vulnerabilities and market tightening could trigger funding problems in the event of market strains. Market turbulence may make it more difficult for banks to manage currency gaps in volatile swap markets, possibly rendering some banks unable to roll over short-term dollar funding. Banks could then act as an amplifier of market strains if funding pressures were to compel banks to sell assets in a turbulent market to pay their liabilities that are due. Funding pressure could also induce banks to shrink dollar lending to non-US borrowers, thus reducing credit availability. Ultimately, there is a risk that banks could default on their dollar obligations. …

The crunch hit at the end of the third quarter, when European banks’ short-term credit line in US dollars had to be renewed. Data for the volume of interbank lending aren’t available yet, but the cross-currency “basis swap” between Euros and US dollars – the spread that banks charge their customers for expanding their balance sheets to provide foreign exchange hedges – suddenly widened.

Remember that the bond markets are much larger than the stock markets. When bond markets move, they cause the stocks to move too.