Bilal’s Macroscope: Not a Banking Crisis, But a Crisis of Time

All of finance can be boiled down to time. How much is time worth to someone? What is needed to induce people to give up consumption today to invest for future gains and what is the price of time? It is the interest rate. This means that when interest rates are low, then the price of time is low. Suddenly, cashflows far in the future become more valuable.

It is no wonder that low rates tend to support loss-making companies; investors are willing to ignore the current losses for the promise of future gains. Investors are putting a low price on time. Such dynamics imply that investors all become long duration. After all, duration is the time needed to repay the loan or bond. You don’t mind being long duration if time is on your side.

Duration vs Credit Bubble

The period of low rates since the global financial crisis and turbo-charged in the immediate aftermath of COVID, can be characterised as a duration bubble, when viewed through this filter. Everyone stopped valuing time, instead rewarding gains in the far future. This included anything from unicorn start-ups, to crypto to private equity.

This stands in contrast to the 2000s and the global financial crisis, which was a housing-linked credit bubble. Back then, new forms of leverage were created to invest in poor quality assets (sub-prime housing). Banks were at the heart of the leverage cycle. When they broke, the system collapsed.

In this way, the recent bank failures of Silicon Valley Bank (SVB) and Signature Bank in the US and worries about Credit Suisse in Europe are not a repeat of the global financial crisis. Rather they reflect the bursting of the duration bubble. That is, higher rates from the past year, has suddenly made time valuable again. Whether investors know or not, they are all moving to reduce their duration.

It is no coincidence that crypto bank Silvergate preceded the SVB collapse. Nor that SVB’s deposit run was mainly VC-backed start-ups. The underlying cause was the collapse in the valuations of crypto and loss-making start-ups in an era when the present is worth much more than the future, thanks to higher rates.

Is Private Equity Next?

This framework allows us to understand where the risks in the system lie. Parts that benefited from low rates and expectations of distant future gains will suffer. In the end, these parts will be repriced lower. In some cases, this is immediate, in others it is delayed. For US regional banks, accounting helped delay a reckoning. They were able to carry losses in their bond holdings due to ‘held-to-maturity’ (HTM) accounting. But a deposit run has brought scrutiny to these assets.  Lucky for them they hold credit-worthy government bonds.

The biggest risks could lie in private equity (PE). They heavily invested in tech companies, which are benefited from low rates and so were long duration. PE mark their own books, which could be masking future losses. Meanwhile, their underlying investors have made capital commitments . The hope is that PE firms can ride out any downturn.

Yet, when everyone starts to care about time, underlying investors may to pull their commitments and investments may need to be liquidated which reveals the true valuations and so on. It happened suddenly for US regional banks, it could equally happen suddenly for PE firms. However, unlike banks, the Fed is unlikely to accept their assets as collateral, given they are levered companies and not government bonds.

PE firms have dramatically outperformed the S&P500 over the past five years. That is the vulnerability to watch.

Our Current Discretionary Trades

Our model portfolio performed well over the past week, it gained over 1%, despite the market volatility. Here are our latest trades:

1. Long 5Y TIPS vs US 2Y (target: 90bp) – read here.
   • Trading the Fed need not be directional. Mustafa sees value in buying TIPS and hedging it with the nominal US 2Y to trade both the ‘end of the Fed cycle trade’ or the ‘hard landing’ scenario.
2. Short BTP vs Bund 10-year (target: 220bp) – read here.
   • Henry sees the BTP vs Bund 10Y spread trade reaching 220bp.
3. Long UK 2Y (target: 3.2%) – read here.
   • Henry previously rotated to being outright long UK 2Y, with the recent collapse in yields providing well-earned fortune.
4. China re-opening – read here.
   • Long SHCOMP (target: 3,600)
   • Short USD/CNH (target: 6.65)
   • Short USD/COP (target: 4,100)
5. Receive 2Y INR OIS (target: 6.0%) – read here.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)