March 19, 2023
The End Game
Well, that escalated quickly!
As the saying goes, “there are decades where nothing happens; and there are weeks where decades happen.”
The past week has certainly felt like the latter. Just as I thought I could quietly head off skiing and ponder Powell’s testimony and the direction of monetary policy, a potential banking crisis in the US spiked volatility and drove a dramatic re-pricing in rates and the outlook for Central Bank policy.
Powell’s “hawkish” testimony saw a swift move to price a higher probability of 50bps of hikes in March with terminal rates around 5.7%, to pricing zero for March and 100bps of cuts over the next 12 months. The following graphic taken from ZeroHedge shows the dramatic repricing in rates over the course of a week.
Macro Takes a Back Seat
Macro data has taken a back seat to the unfolding of events within the banking sector following the announced failure of Silicon Valley Bank, the second largest US bank failure in history, alongside the failure of Signature Bank. This also followed the earlier announcement of the voluntary liquidation of crypto focused Silvergate.
It’s been said that the Fed will hike until something breaks. Somewhat perversely, I was hoping that “something” would be the economy and inflation, but concerns now are once again focused on the financial system.
At the heart of the issue at Silicon Valley Bank (risk management practices aside) was a de-facto bank run, with deposits leaving the bank in search of higher money market yields. As a result, liquidity issues quickly morphed into solvency issues as SVB needed to sell their US treasury assets which were under water given the Fed’s sharp rate hikes.
After a failed weekend scramble to find a buyer for the embattled bank, in an attempt to shore up confidence and prevent contagion, US regulators guaranteed the deposits at both SVB and Signature Bank.
They also announced The Bank Term Funding Programme (BTFP), allowing banks to access liquidity to manage deposit withdrawals, with loans up to 1 year in exchange for UST collateral which will be valued at par (and not the lower mark to market valuation). More on this later.
Calm was restored to markets on the Monday open, but as is always the case when confidence starts to drain from markets, there’s never just one cockroach.
The following “domino” was Credit Suisse which saw its share price plunge and CDS spike as its major shareholder, the Saudi National Bank, ruled out further investment, culminating in the Swiss National Bank providing a SFr 50bn liquidity backstop. Regulators are still scrambling this weekend to seal a UBS takeover deal.
The game of whack-a-mole then reverted back to the US, with First Republic Bank shares down 70% over the week after again suffering deposit outflows. On Thursday, Wall Street giants including Bank of America, Goldman and JP Morgan, amongst others, committed to depositing $30bn to shore up the bank’s liquidity position.
The reason money and deposits are flooding out of banks is that deposit rates are too low relative to money market rates. Banks are unable to hike deposit rates given inverted yield curves which would make them unprofitable if they were to do so. Put another way, Fed rates are simply too high for the banking system to handle.
The BTFP short-term can help prevent a liquidity crisis. The ability for banks to exchange that collateral at par also helps stave off a solvency crisis.
Side note: ✍️ Banks received a flood of deposits during the Covid crisis as massive fiscal stimulus injected cash into the economy which found its way into bank deposits. Those deposits were placed into longer duration, “safe” assets such as treasuries and MBS securities, looking to earn some yield (when yields at the time were at the zero lower bound). The Fed’s sharp hike cycle has driven the value of those assets substantially lower. However, banks aren’t required to mark these to market if they’re deemed as “Held to Maturity” and so are valued at par, masking potential solvency issues. Solvency becomes an issue if banks are forced to sell those assets and realize a loss to raise liquidity. Hence the BTFP was introduced last weekend to both provide liquidity and help avoid a contagious chain of insolvencies.
Ultimately, the Fed will need to pause and eventually get rates lower. Liquidity provisions such as the BTFP and the Fed’s discount window can provide a short-term solution to plaster over the cracks. However, bank deposits will continue to flood out, and banks will become increasingly dependent on Fed liquidity.
Just this past week, the Fed balance sheet increased a MASSIVE $300bn as banks tapped the various liquidity facilities at the Fed (albeit only 11bn of the BTFP was used.) This unwinds most of the Quantitative Tightening since October.
The idea then that the Fed can hike rates on the one hand to address inflation whilst providing liquidity to help the banking sector suffering outflows on the other looks improbable. The Fed’s balance sheet will explode! Further, the BTFP whilst a good deal on exchanging at par collateral value, is priced at Fed funds plus 10bps so still relatively expensive for banks and not sustainable.
The Fed faces an impossible choice between inflation or the financial system. Now they pause and pray that inflation comes lower.
For what it's worth, I think inflation will come sharply lower. Bank lending will necessarily freeze and we’re looking at a credit crunch. Data this past week also suggests that the uptick in Feb data was simply a blip. Headline CPI came in at 6.0% down from 6.4% the month prior and PPI came in at 4.6% (Vs. 5.7% the month prior and against expectations of 5.4%.) The peak inflation narrative is back on track. Retail sales also came in weaker than expected at -0.4% on the month, down from 3.2% prior and Uni Mich inflation expectations and consumer sentiment also softened once more. The lagged impact of monetary policy is starting to be felt.
Overall, Central Banks are trapped and what we’re witnessing is ultimately my long-term bullish macro thesis for crypto playing out real time. That is, the fiat system is unable to sustain higher rates, and is reaching its natural endpoint. Let me explain.
The End Game
I came to crypto having had a front row seat to the Great Financial Crisis in 2008. The fiat, credit-based system had reached its end goal. However, the short-term pain of allowing financial armageddon was too painful a decision for anyone to take. So central banks and governments intervened, printing money and artificially inflating financial assets, which were the collateral underpinning the leverage in the system. Central bank balance sheets exploded higher. Liquidity flowed into financial assets, and fiat currencies debased, driving an inequality divide. Asset owners became wealthier. Wage-earning workers became poorer.
There are no differences in the fiat system today compared to the one that was bailed out in 2008 and again in 2020. The debt piles and leverage are higher, central bank balance sheets are more inflated. The ability to withstand a prolonged rate hike cycle is diminished, and we’ve witnessed that impact on financial markets. Central banks are no longer just about controlling inflation, they’re a central part of market functioning and liquidity provision.
As central banks attempt to remove the last decade of stimulus to try and control inflation, they risk blowing up the entire financial system. With the cost of living crisis, inflation is the dominant consideration currently. However, we are approaching the point where impossible choices need to be made once more. The lesser of two evils will once again come out on top, to artificially inflate assets, save the financial system and sacrifice fiat currency.
We’ve had brief episodes in the past year where that default intervention occurred, most notably with the Bank of England, who in the midst of a hiking cycle, were forced to intervene and buy UK Gilts to stop the UK pension system blowing up.
This is now the turn of the Fed to stop regional banks from blowing up and staving off a liquidity crisis that could quickly morph into a solvency crisis. All of this of course stems from the impact of an aggressive hike cycle with little regard to the lagged impact from monetary policy. Deposits leaving banks to park in higher-yielding money market funds. Inverted yield curves making it impossible to pay depositors higher yields to lend long and make spreads.
There’s going to be lots of twists and turns over the coming weeks as this situation plays out. I suspect we’ll see other banks in trouble and continued use of Fed liquidity facilities which sees the Fed’s balance sheet back in expansion mode. Bitcoin and the wider crypto complex is starting to move higher as this tide of liquidity returns.
We’ve seemingly reached “breakpoint”. I expect the Fed will pause this coming week, to give time to assess the fall out. The hike cycle is likely done as a freeze in bank lending and bank failures will quickly feed into the real economy and start to bite. Short-term volatility aside, this is the ultimate end game for crypto playing out. The fiat system is reaching its endpoint, unable to sustain higher rates, saved by Central Banks, sacrificing fiat currency. We’re back to the original, powerful narrative which led to the birth of Bitcoin.
A Fed pivot, when it arrives, will fire the starting gun on the next crypto bull market. Finally, that moment looks to have begun.