As the Fed rate hikes continue, risk to the financial system increases because all markets are interlinked. Systemic risks to the financial system have increased and may converge. A misplaced bet in structured credit could backfire—causing interest rates to rise. Narrowing credit spreads could cause the carry trade to unwind—forcing leveraged players to dump their bond holdings—leading to a jump in interest rates. A trade war could create friction in the credit markets—forcing central banks to dump their Treasury holdings or go on strike with new buying. A rise in interest rates could make mortgage payments untenable for overburdened households—triggering bankruptcy. Increased bankruptcies would bring more homes on the market—increasing supply and causing home prices to fall. Falling home prices would increase homeowners and lenders risk as equity evaporates. Each tipping point could lead to the next as they are all connected in a daisy chain.
What is clear is that this rate cycle is different. The Fed has very little room to maneuver nor can it afford to make a mistake. The economy is more leverage today than back in 1999. Outstanding debt has grown by $10 trillion since the last time the Fed raised interest rates. The leverage in the financial system has grown exponentially with derivatives and the carry trade. The homeowner has gone deeper into debt, the government is running large budget deficits, and the trade deficit is the worst it has been in this country’s history with no sign of improving. We have no margin of safety. Things will have to workout perfectly in order to avoid a crisis. Will we be that lucky?
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