One of the Biggest Risks in the Loan Market That Nobody’s Talking About

  Declining rates have given everyone – especially bankers – something to talk about. With negative yields on 10-year government bonds in countries such as France, Germany, Sweden, the Netherlands, Switzerland and Japan, it’s no surprise that rates are top-of-mind.

“If you’re a banker, and you have to pay someone to take out a loan, that wouldn’t sit too well,” notes Greg Sweeney, Bell Bank’s chief investment officer.

There are 3 potential factors driving negative yields:

  1. Regulations that require businesses like insurance companies and pension funds to have a certain amount of bonds
  2. Fear that the economy will slow significantly
  3. The possibility of a deflationary economic environment on the horizon

Greg says it’s “very perplexing” to see negative rates in some countries, but he doesn’t expect it will happen in the U.S., partly because our banking system is a fractional reserve system, and banks are not interested in paying people to take out loans. He also speculates that we’re learning from other central bank mistakes.

“We’ve probably learned enough lessons from those countries to suggest that driving rates negative is not the solution we’re looking for,” Greg remarks. “If the low-interest-rate environment driven by the Federal Reserve’s monetary policy doesn’t work to drive economic growth and stronger inflation, I think there will need to be a fiscal policy solution coming from Congress. In any case, they will stop and have to look for something else if it’s not functioning as intended.”

During the last recession, for example, Congress voted for a tax rebate to put money into the system to try to drive economic growth higher.

Currently, in the U.S., we’re seeing:

  • Declining short-term rates in response to a reduced Fed funds rate
  • A flattening yield curve shifting to a slightly upward sloping yield curve that’s expected to remain muted
  • Interest rates on 10-year treasury bond expected to be between 1.5% and 2.25%

But Greg says what’s even more interesting, and what very few people are talking about, is that the lower interest rates get, the more volatile bond prices become.

“Duration is a measure of volatility,” Greg explains. “That’s probably one of the biggest risks in the bond or loan market that nobody’s talking about. For every decrease in interest rates, the risk measure for bonds and loans increases, so there’s risk creeping into bond and loan portfolios that many people don’t understand.”

When that happens, Greg says, the market value of bonds fluctuates a lot more, so there is equity market risk creeping into bond portfolios.

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