Leverage is now likely in different places than during the global financial crisis. We have seen large-scale disintermediation of the banking system into less well-regulated and more opaque areas. This just means that the vulnerabilities may play out in different areas than in the past.
Market pricing in soft landing is unrealistic
The other area where leverage has increased is on government balance sheets. During Covid, there was a large scale transfer of leverage from the private sector to the public sector. This has a few consequences. First, fiscal balances are now largely tapped out. When the recession comes, it will be hard for governments to spend their way out.
Second, global governments need to sell many new bonds. Recently, a lot of issuance has been in the Treasury bill market, but as we move into 2024, much of these bills will need to be termed out and replaced with longer-maturity debt.
Who will buy all this duration, especially at a time when central banks are stepping back from bond purchases?4 The implication is higher long-term bond yields. So while eventually central banks will respond belatedly to recession with rate cuts, there is the potential that the calming power of those official rate cuts may be offset by a lack of response in longer yields. A late, blunted, and incomplete response could lead to a deeper and longer malaise.
A soft landing is consensus. In the near term, China’s stimulus and potentially a build in inventories may prolong the good mood. But a hard landing is much more likely in the longer term. The only questions are when those long and variable monetary policy lags will show their inevitable dominance and how to navigate that journey.
Arif Husain, head of international fixed income, T. Rowe Price
1 The Inflation Reduction Act and the CHIPS and Science Act were both enacted in 2022.
2 Financial conditions are measured by Treasury yields, credit spreads, stock prices, and the price of the US dollar.
3 Data source: Bloomberg Finance LP.
4 Duration measures a bond’s sensitivity to changes in interest rates.
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