The Macro Compass

Brazilian President Lula recently asked the following questions:

‘’Every night I ask myself why should every country have to be tied to the US Dollar for trade?’’‘’Why can’t we trade in our own currency?’’‘’Why can’t a BRICS Central Bank have a currency to finance trade between BRICS countries?’’

Lula’s speech sparked yet another mediatic hype on the upcoming De-Dollarization.

So, let’s explain how today’s USD-centric system works and why it’s been impossible to replace in 50+ years.

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Now, back to it.

In a globalized economic system you want to trade with as many partners as possible in a seamless way.

When Brazil exports its commodities to China or Japan and the trade happens in USD, Brazil accumulates Dollars – it might also use them to buy goods or services it needs from other countries.

In other words, today the US Dollar is the Global (Reserve) Currency of choice: over 80% of global FX transactions and 50%+ of global trades and payments happen in US Dollar.

More importantly, in the last 30 years competitors could not alter this massive USD dominance: why?

Well, it’s because being the US Dollar seems fun from the outside.

But it ain’t easy.

Let’s start from the asset side.

When Brazil exports commodities in USD more than spends USD to import stuff from the outside, the country accumulates USD foreign exchange reserves.These USDs enter the domestic banking system, and ultimately the local Central Bank is responsible for managing this FX reserve buffer – that means keeping these US Dollars safe and liquid.

In our monetary system, keeping money ‘’safe and liquid’’ means avoiding credit risk and investing in deep and liquid markets that guarantee a painless turnover if necessary (either via selling or repo-ing securities).

The US Treasury market stands out as the global leader in this field: as big as 20+ trillion in size, liquid and underpinned by a deep repo ecosystem it ticks all boxes.

No capital controls, democratic roots and the rule of law reinforce the case.

Most importantly, an ample supply of US Treasuries (read: deficits) provide to the rest of the world what they need: a safe and liquid asset where to recycle the USD proceeds from their global trades.

But so, what’s the potential alternative?

Japan? Its government bond market is 60%+ absorbed by the BoJ, and there have been multiple days in a row (!) where no trade happened in the JGBs – how can you store your FX reserves in such an illiquid market?Europe? With such a fragile monetary but non-fiscal union, and the only AAA countries potentially able to provide the world with safe collateral (German Bunds) instead sticking to austerity for decades?China? Brazil? Russia? You are facing a combination of capital controls (China), lack of democracy/rule of law (Russia), corruption and frequent episodes of double-digit inflation (Brazil) – do you want to take these risks when storing your hard-earned FX reserves accumulated from selling your goods and services abroad?

The truth is that US Treasuries don’t have a valid competitor as a global vehicle where to invest FX reserves.

And this is also true for the other side of the coin: debt.

USD-denominated foreign debt is huge, and it makes an orderly De-Dollarization not more than a fairytale.

Entities sitting outside the United States have accumulated $12 trillion of USD-denominated debt: this is because to finance global businesses that sell stuff in US Dollars…well, you need US Dollar debt.

I can’t stress how important it is to understand this concept: if you want to break this system and ‘’De-Dollarize’’, you need to deleverage a $12 trillion debt system.

Brazil walking away from USD-denominated trades would hamper its own organic inflows of US Dollars, and Brazilian corporates would be choked under USD scarcity as they need to repay and refinance their USD debt.When you de-leverage a debt-based system, you are either bidding up the debt denominator (the USD) or you are witnessing tectonic geopolitical events (e.g. wars) where the world order is at stake.

An orderly unwind of the US Dollar is a fairytale: there is no valid alternative for a smooth transition, and de-leveraging the global USD debt based system would be a very painful process.

And this is why you keep hearing about the De-Dollarization, but it never happens.

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Hedge funds are often called fast or smart money because they are one step ahead of herd market thinking.

I am blessed with the opportunity to have several of them as clients, and pick up their brains on what they are watching in markets and what the next big macro trade might be.

In this piece, I will share with you 5 macro developments and charts hedge funds are watching.

1.    Are you watching the deflationary tails?!

The Minneapolis Fed runs an excellent algorithm that plots the market-implied distribution for 5-year ahead expected inflation in the US (here).

It uses options on inflation-linked products to determine what investors are expecting as base case, and what they are willing to pay for upside (hot inflation) or downside (disinflation) in US CPI over the next 5 years.

If we compare today’s distribution (blue) versus 2 years ago (red) we notice that the median base case for investors is that US inflation will average around 2.25% over the next 5 years: quite a comfortable sight.

But the devil is in the (de)tails.

While 2 years ago the 10th percentile of the distribution settled at 1.56%, today is sits at 0.63% - quite close to actual deflation.The ‘’hot inflation’’ tail (90th percentile) is also a bit higher at 4.63% vs 3.76% in 2021.

While the base case for inflation ahead is very benign, today investors are more worried about tails than they were in 2021.

And in particular deflationary tail risks are staging a comeback.

2. Bond market volatility: look under the surface…

As the banking crisis was unfolding, bond market volatility literally exploded: the cost to hedge against an abrupt Fed cutting cycle skyrocketed, and bond market liquidity quickly evaporated.

Lately, as we find out the world is not coming to an end anytime soon bond market volatility is quickly receding…but are we out of the woods?

This chart shows the 3-month market-implied volatility in US 2y rates (orange, RHS) and 30y rates (blue, LHS).

Bloomberg users can find the tickers here: USSN0C2 BGN Curncy and USSN0C30 BGN Curncy.If you don’t have Bloomberg, you can find and chart these tickers on our Volatility-Adjusted Market Dashboard (tickers: US 3m2y Swaption ATM Vol, US 3m30y Swaption ATM Vol).

This chart is interesting because it shows that while front-end bond market volatility (orange) receded but remains elevated, the long-end (blue) seems to be much less uncertain about future outcomes.

Why?

As this hedge fund client eloquently puts it: the Fed can have a strong influence on 2y rates, but 30y rates are rather based on investors’ expectations and uncertainty about future growth and inflation.

And there is not much to be uncertain about there – the Fed is on a mission to kill growth and inflation, 30y rates know it and you never fight the Fed.

Which brings me to the 3 most crucial charts hedge funds are watching to find the next big macro trade, and that you should care about too.

Let’s dig in…

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Hey guys! Before we start, an important announcement: welcome to the first piece of the TMC Macro Education Series!

Once a week, I will deliver some bonus educational content covering big picture macro trends, the bond market, monetary mechanics, risk management and more in a quick, 5-min read.

Financial education is a key TMC principle – hence the Macro Education Series is and will always remain FREE.

I hope you enjoy it!

Long-term, structural economic growth is mostly driven by two factors: demographics and productivity.

Both peaked in the late 80s, and we chose to fix the problem with a ton of debt.It worked until now, but we are at very late stages of the long-term debt cycle.

Healthy demographics and high fertility rates facilitate a growing labor force: retirees are more than offset by new young workers, and hence the share of working-age population as % of total increases.

More workers, more potential for growth.

Over the next decades though, the share of working-age population will decline across many countries: for instance, the Chinese workforce is likely to shrink by 250-300 million people – a hard hit for global growth.

Total factor productivity (TFP) growth measures how productive are capital and labor resources.

Effective capital allocation and technological progress contribute to achieving positive productivity growth.

As the marginal benefit from technological progress declines over time and capital misallocation took center stage over the last 1-2 decades, TFP growth stagnated around 1% per year – not exciting.

As per the early 90s, labor force and productivity growth trends weakened materially.

Potential GDP growth started declining to socially and politically unacceptable levels – so, how did we fix that?

With a ton of debt.

Public + private debt levels as % of GDP amongst developed economies skyrocketed from <200% to over 300% in less than 2 decades, and in China from 100% to 300% in less than 15 years.

Be it mostly through government (Japan) or the private sector (China), credit creation was the ‘’easy fix’’.

To be precise: cheaper and cheaper credit.

Real interest rates relentlessly declined for 3 decades, allowing a system with lower structural growth offset by more and more leverage at cheaper and cheaper borrowing costs to thrive.

The more unproductive debt, the lower real yields must be for the system to survive.

This long-term debt cycle is at its very last innings.

Fighting inflation requires higher real yields, and our over-leveraged system can’t bear that.

And once you deleverage a credit-based system, it’s hard to get it back on its feet.Just ask Japan.

If you have enjoyed this piece, consider joining The Macro Compass premium platform.The best investment you can make is in your own macro education, and TMC is trusted by thousands of worldwide investors to deliver unique and actionable macro insights every week.

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This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Before we start, a quick announcement: starting this week, I’ll be kicking off The Macro Education series!

I will publish short and educational pieces covering the bond market, monetary mechanics, portfolio construction, risk management and much more.

It will be and it will forever remain FREE.Looking forward to share some educational macro insights with this nice community!

When the yield curve flattens and eventually inverts, you worry.But it’s when a recession hits, the Fed cuts rates and the curve steepens that you become s**t scared.

Yield curve dynamics represent a crucial macro variable, as they inform us on today’s borrowing conditions and on the market future expectations for growth and inflation.

An inverted yield curve often leads towards a recession because it chokes real-economy agents off with tight credit conditions (high front-end yields) which are reflected in weak future growth and inflation expectations (lower long-dated yields).A steep yield curve instead signals accessible borrowing costs (low front-end yields) feeding into expectations for solid growth and inflation down the road (high long-dated yields).

Rapid changes in the shape of the yield curve at different stages of the cycle are a key macro variable to understand and incorporate in your portfolio allocation process.

Hence, in this piece we will:

* Quickly walk you through the different yield curve regimes (i.e. bull steepening, bear flattening etc);

* Analyze 50+ years of asset classes returns through these different regimes;

* Assess where we stand today, and what the labor market is telling us about the macro cycle;

* Conclude with our actionable investment strategy.

* Bull Flattening = lower front-end yields, flatter curves.

Think of 2016: Fed Funds already basically at 0% and weak global growth. Yields stay put at the front-end and could meaningfully move lower only at the long-end, hence bull-flattening the curve.

* Bull Steepening = lower front-end yields, steeper curves.

Late 2020, early 2021: the Fed was keeping rates pinned at 0% and stimulating via QE but the economy was flooded with fiscal stimulus and ready for reopening. The friendly borrowing conditions and the massive upcoming growth boost could mostly be reflected through higher long-end yields, while 2-year interest rates were pinned at 0% by the Fed. Bull-steepening of the curve.

* Bear Flattening = higher front-end yields, flatter curves.

2022 was the bear flattening year: Powell raised rates aggressively to fight inflation, but he ended up choking the economy off. This was reflected in lower future growth and inflation expectations at the long-end of the curve. Front-end rates went higher, but the curve bear-flattened.

* Bear Steepening = higher front-end yields, steeper curves.

Do you remember 2009? The worst of the GFC was behind us and (monetary-mechanics-illiterate) investors were afraid that QE would lead to runaway inflation and the Fed would be forced to start acting on it. Front-end yields moved a bit higher, but long-end yields took most of the hit as investors (mistakenly) bumped the inflation risk premium up = the curve bear-steepened.

Rapid changes in the shape of the yield curve when growth is at turning points are a key variable to consider for a successful asset allocation process.We looked at 50+ years of cross-asset returns through different growth and yield curve regimes, and here is what we found:

The implications from this table are crucial for your portfolio allocations.

Let’s dig in…

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Soft landing, no landing at all, banking crisis leading to an immediate recession.Chinese reopening yes, reopening no.S&P 3850, 4200, no again 3850, wait it’s back up to 4150.

Push & pull macro and market dynamics dominated Q1, leaving investors confused on how to approach Q2.

This is why in this piece we will:

* Quickly review Q1 through the lenses of Volatility-Adjusted market performance across asset classes;

* Refresh the key variables behind our quantitative TMC Asset Allocation Model;

* Reflect on asset classes valuations and conclude with our ETF Portfolio allocation to kickstart Q2.

For long-term macro investors, Q1 brought mildly positive returns with a truckload of volatility and went away without marking the start of any major macro trends.

Reminding ourselves that US cash equivalent products yield ~5%, there was little to be excited about.

Our Volatility-Adjusted Market Dashboard (VAMD) screens global macro asset classes returns from a risk-adjusted performance, and it shows a 3-month Z-Score <1 for most assets = no major vol-adjusted action.

Rather than in being outright long or short a certain asset, the most significant Q1 macro trend was a rotation in US equity sectors.

Tech and Consumer Discretionary largely outperformed defensive sectors like Healthcare and Utilities.

But why?

This excellent chart from Goldman explains why: mechanical re-leveraging flows, not fundamentals.

Back in November, Powell was channeling his inner Volcker – no end in sight for the hiking cycle, and the most hated assets in such macro environments are high-beta, unprofitable tech/meme companies.

Fast forward to early 2023: disinflation first and a more prudent Fed after the SVB saga bring in systematic flows and ‘’pivot buyers’’, leading to a massive short squeeze.

Nothing to do with fundamentals, but a good reminder to respect the power of macro-insensitive flows.

So, with that in mind how do we approach Q2?

First: the macro fundamentals.

The TMC Quadrant Asset Allocation Model (QAAM) blends together monetary policy and economic growth indicators to identify the prevailing Macro Quadrant and hence the most appropriate asset allocation tilt.

It combines that with an assessment on valuations, correlations and portfolio volatility to come up with the final allocations depleted in the Long-Term Macro ETF Portfolio.

The Y-Axis of our QAM tells us the global monetary policy stance remains tight due to elevated and sticky real yields, and about to get tighter as the flow of financial money turns more negative.

Long-dated real yields are now positive and above equilibrium in many jurisdictions, and that is negative for growth and markets as our debt-based system struggles to roll over cheap leverage.

In the US, sustained periods of above-equilibrium real yields lead to poor market performance (2015, 2018).

In 2022, it was the rate of change in real yields that scared markets: going from the -0.75% March YOLO levels to the +1.50% October ‘’Powell = Volcker’’ levels in only 6 months required tectonic adjustments in valuations.

Since then, real yields have stabilized but have averaged a tight +0.93% for 6 months already.

In Q2, real yields are likely to remain in tight territory again.And markets don’t like tight conditions, especially if they last for a long period of time.

Ok.

But what are we really doing QT or are Central Banks printing money?How does that affect macro and markets in Q2, and how to best position portfolios?

Let’s dig in…

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The world is big, and macro investment opportunities pop up where you least expect them.

Looking beyond the US and focusing on true global macro is an underrated and fruitful exercise.

So, let’s do that.

In this piece, we will cover the latest macro developments and discuss trading opportunities in Europe, China, Japan…and yes, ok, we will sneak in a quick word about US liquidity too – very important for global markets.

China - Opportunity or Bull Trap?

Let’s start from China: what about the reopening trade?

The Chinese Communist Party’s plan put in motion back in 2021 had as its first objective to clamp down speculative behavior in sectors that weren’t considered ‘’in line’’ with the CCP’s views for China: excessive animal spirits in the real estate and tech sectors were to be tamed.

And they were – a substantial deleveraging was achieved, which brings us to the second step.The Chinese reopening: bring back domestic consumption and steer growth where you want to see it.

So, where do we stand there?

Chinese official data is often to be taken with a pinch of salt, but here is an interesting take on PMIs:

The New Orders subindex just printed at multi-decade highs (orange), while the Exports subcomponent has rebounded but not nearly as much (blue): the Chinese reopening is real, but it’s been met by sluggish global growth and hence exports struggle to pick up.

Don’t trust Chinese official data?

Alternative data show how domestic flights are up 40% YoY, and a pickup in international flights should follow with holiday season and higher temperatures.

On top of it, China has pre-emptively stimulated in H2-2022 delivering a solid flow of credit to corporates.

As this interesting chart from Clocktower shows, once China credit creation picks up (purple) it’s only a matter of time before Chinese equities (blue) rally.

Chinese equities continue to look attractive over the medium term here, with stock indexes still well below the January highs and with a 10%+ potential upside based on broader macro data further reflecting the reopening trends in Q2 and supportive credit creation.

This view is reflected in our Macro ETF Portfolio, where…

Eager to check out Alf’s Macro ETF Portfolio and trade ideas?Want to keep reading his global macro analysis on Europe, Japan and the US?

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In 1992, judge Giovanni Falcone was killed by the Sicilian mafia.

Falcone and his colleague Borsellino were at forefront of major investigations that uncovered much of the mafia’s business and led to the incarceration of many criminals.

His method was pretty simple: follow the money, find the mafia.The same methodology can be very useful in understanding the real extent of today’s banking stress, which is crucial for macro and markets going forward.

Follow the money, assess the banking stress.

That’s why in today’s piece we will:

* Show you how to ‘’follow the money’’, explaining which reports to focus on and how to analyze them week by week to assess the depth of the banking stress;

* Refresh our market views and actionable long-term macro ETF portfolios.

Let’s follow the money together.

If banks are under stress from deposit outflows, they sure will be tapping the available liquidity facilities.

So, have they? And by how much?

Before we answer this question let’s first define which liquidity facilities are available to US banks – they differ in conditions, eligible collateral, loan tenors etc.

A) The Discount Window (Fed): very wide set of collateral accepted (not limited to Treasuries and MBS, but also some loans) at market value, max 90 days term lending at top of Fed Funds range (5% now); it comes with a strong stigma from the GFC.

B) BTFP (Fed): newly created Fed facility that accepts Treasuries and MBS without any liquidity or market haircuts (!) and lends for up to 1-year at 1y OIS (~Fed Funds) + 10 bps (4.75% now);

C) FHLB Advances (not Fed): the Federal Home Loan Banks program that allows member banks to post collateral with haircuts (UST, MBS and some mortgage loans) and at market value to get funding (‘’advances’’). Funding duration is flexible, but FHLB advances are relatively more expensive.

Here is a very handy table from JP Morgan summarizing the 3 facilities:

So, let’s now follow the money – did banks use these facilities, and by how much?

The Fed’s H.4.1 report is released every week (here) and it informs us on the Discount Window and the BTFP.

Banks drew $160 bn from these facilities in the SVB debacle week, and net zero (!) the week after.

We also know that First Republic Bank drew about $110 bn from the Discount Window, which means all other US banks only drew $50 bn from the combined Fed facilities 2 weeks after the stress started.

Not much, really.

But maybe banks used the third option - FHLB Advances more aggressively?

FHLB disbursed loans to commercial banks are only reported quarterly, but you can track the amount of money FHLB is raising through bond issuance here – even if not fully distributed, it gives us an idea about the potential incoming demand FHLB expects.

Now, stand ready for the number.The FHLB has raised as much as $300 billion in the last 7-10 days, largely outpacing its normal issuance pace.

A huge figure.

So, are US banks truly experiencing severe stress after all?Let’s keep following the money together to find the answer to the most important question for markets right now…

Eager to read the remaining part of this macro report?

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The Fed understands that banking stress is ultimately disinflationary as the flow of credit to the real economy slows down and so does economic activity, and inflation with it.

Markets are now busy interpreting what it all means, and this is why in this timely piece we will:

* Discuss the 2 most important takeaways from the Fed meeting;

* Assess market reactions across asset classes, with a particular focus on the bond market;

* Disclose the resulting tactical trade ideas

Wait: Have We Broken Something Here?

“Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.”

With inflation sticky and still trending above 5%, for the Fed to come out of the gate with a forward-looking statement like this is quite something.

Powell & Co deeply understand the disinflationary nature of banking stress.

This was also reflected in the economic forecasts, and particularly in the uncertainty surrounding them.

Due to the banking stress, a large number of FOMC participants is worried about downside risks to GDP growth while less and less participants expect upside surprise on inflation.

In other words, the FOMC is more worried about a disinflationary recession than anything else.

“The Committee anticipates that some additional policy firming may be appropriate to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”

From “ongoing rate increases” to “some” and “may”.

Again, this shows that the Fed will be on the lookout for signs that they might have done enough damage through this banking stress.

This is something deeply new, as until now the Fed was effectively on autopilot: keep monetary policy incrementally tight until you get people unemployed and inflation comes down.Don’t make any assumptions, just get the job done.

Here, we are looking at a different Fed.And the Summary of Economic Projections (SEP) clearly shows it.

Despite predictions for lower unemployment rate and higher core inflation in 2023, most likely to account for the banking stress uncertainty the median Fed Dot for December 2023 wasn’t revised higher.

This is a proactively cautious Fed looking to assess the damage despite inflation still running hot.

But the second point was even more important, as it led to crucial market moves and therefore opened the door to some interesting market opportunities.

Let’s dig in…

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The giant Swiss bank Credit Suisse is no more.Central Bankers have announced several facilities during weekends to calm markets down.The 2008 vibes are very strong – what now?

In this piece, we will provide you with a level-headed analysis of:

* The Credit Suisse deal, including its repercussions on the broader European bank and credit markets;

* The scope and effectiveness of the Fed’s BTFP facility and the reactivation of global $ swap lines;

* How are we managing our portfolio, and what lies ahead for markets.

Credit Suisse has been acquired by UBS for $3.3 billion in a deal brokered by the Swiss government over the weekend – the deal also includes about $10 billion the Swiss government will cover for potential CS losses hitting UBS and around $108 bn of liquidity facilities the Swiss National Bank will make available to UBS.

This is a decent deal for UBS, and yet markets were unhappy because of one important detail.

While CS equity investors got (some small) residual value out of the deal, $17 billion of CS’ Additional Tier 1 bonds (a “hybrid” instrument between bonds and equities) were completely written down to zero.Regulators decided to sweeten the deal for UBS by sacrificing AT1 investors denying the standard waterfall.

Investors were busy extrapolating that AT1 are now a no-go if regulators can subordinate these bonds to equity capital in events of stress – returns don’t warrant the risk in these bonds, and the AT1 market in Europe is pretty big at $275 billion.

That’s an incorrect extrapolation, in my opinion.

If they did their homework (I doubt…), CS AT1 investors knew already the risks they were running: the absence of “write-up” mechanism is very clear for these bonds, which means the risk of getting marked down to zero if a Viability Event/AT1 Trigger (read: bank about to go belly up) occurs is high.

Such a permanent write-down in AT1s is NOT the standard in Europe, as you can see below:

So, yes: CS AT1 investors have been penalized but they knew they were running permanent write-down risks.

And no: the AT1 market in Europe is not dead and the spill-over risks in the banking sector are low.

After the GFC, the bilateral unsecured exposure between banks has been massively reduced: unsecured interbank loans through the Euribor/Libor markets are mostly a thing of the past, and regulators ensured banks are highly penalized for holding uncollateralized bonds issued by other banks (like AT1s).

In other words, that means the direct contagion from the CS debacle within the banking system will be low.

Central Banks have announced plenty of facilities during recent weekends.After the SVB debacle, no other US banks have capitulated yet and the Credit Suisse saga has been solved.

So why are markets still so stressed?

Is the bond market smelling something bad?

Let’s dig in…

Enjoyed it so far and eager to read the remaining part of this macro report?

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This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Market pressures on US banks are now spreading to Europe, where the already troubled Credit Suisse asked the Swiss government for help and got a liquidity boost.

Investors are asking the tough questions now, which means the moment of truth looms large.

Data-driven, holistic macro analysis is crucial to correctly answer these questions.

In this piece, we will:

* Review the current banking situation, assessing the widely different degree of tightness in regulatory and accounting frameworks US and European banks are subject to;

* Do the heavy lifting on digging up the real metrics you need to monitor when assessing the vulnerability banks have to higher interest rates (spoiler: not HTM unrealized bond losses…);

* Conclude with the big picture macro take on banks, and important changes in our Macro ETF Portfolio allocations.

Nothing like a front page of The Economist to tell us we have moved to the panic phase.

Let’s review where we stand, starting from the US.

The US banking regulation and accounting frameworks have some pretty big flaws.Yep, you read that right.

1.      Banks with a balance sheet below $250 bn can act a lot like cowboys…

No need to adhere to NSFR (Net Stable Funding Ratio), a rule that forces large banks to have a good proportion of their liabilities in sticky, long-term funding which limits liquidity risks.No need to adhere to LCR (Liquidity Coverage Ratio): ‘’small’’ banks can buy a disproportionate amount of less liquid securities like corporate bonds or mortgage-backed securities instead of Treasuries.

The problem is that a $249 bn balance sheet bank is not small.For reference, a top 3 German bank has a balance sheet of less than $200 bn – seriously, top 3 in Germany.

This lax regulatory treatment for ‘’small, but not so small’’ banks is very dangerous.

2.      Even large banks booking bonds in HTM are disincentivized (!) to hedge interest rate risks

HTM = friendly accounting: book bonds there, forget about them as they are valued at amortized cost.

Prudent risk management still suggests you should hedge interest rate risk.Yet, US accounting rules disincentivize interest rate hedging for HTM bonds – nuts.

But the cherry on the cake…

3.      No proper interest rate risk stress testing (!!!)

Guys, this is out of this world.

As we will discuss, Europe has a quite extensive framework to stress test the interest rate risk that European banks take on their aggregate balance sheets (the net exposure deriving from loans, mortgages, bond investments, bond issuance, long-term liabilities and swaps).

It’s called IRRBB (Interest Rate Risk in Banking Books) stress-testing.

The US equivalent? It doesn’t exist!Here is the IMF calling US regulators out on the topic:

Please take a second to reflect on how bad this is.

‘’Small’’ US banks are subject to much laxer regulatory requirements.

But even large US banks are disincentivized from hedging rate risk on HTM bonds and even worse they are not subject to extensive stress testing on the overall interest rate risk they run on their balance sheets.

Europe has much tighter regulatory standards and accounting framework, and yet the panic seems to be spreading there too.

So, here are the key questions.

What’s the correct approach to assess how and which US and European banks are really vulnerable to higher interest rates and liquidity risks?

And what’s the big picture macro take here when managing a long-term ETF portfolio?

Let’s dig in…

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