March 27, 2023
Riding the Liquidity Wave
Another volatile week as the focus remains squarely on the banking sector following a weekend that saw Credit Suisse “bailed out” by UBS in a government-assisted takeover. The deal, which came with government (read taxpayer) guarantees on CHF 9bio of “difficult to assess assets” alongside CHF 100bn liquidity support from the Swiss National Bank also saw Additional Tier1 (AT1) debt of CHF 16bn written down to zero. Ouch! The $275bn AT1 bond sector consequently took a hard hit in the week.
Side Note: ✍️ AT1 bonds, also known as Contingent Convertibles (CoCo’s) are the riskiest bonds which can be converted to equity or written off to act as a shock absorber when bank capital levels fall below certain thresholds. They carry high yields in return for the risk and typically rank above equity in the capital structure. However, in Switzerland, the bonds’ terms state that in a restructuring, the authorities do not need to adhere to the traditional capital structure and reserve the right to write these bonds to zero. A right they exercised. Regulators across Europe and Asia have said this week they will continue to impose losses on shareholders before bondholders, but sentiment remains fragile.
The reports earlier this week that the US was discussing deposit insurance without gaining approval from Congress brought some stability. But that was dismissed on Wednesday when Yellen stole JPow’s limelight with headlines hitting the wires that they “have not considered anything to do with blanket insurance or guarantees for assets”.
Banks were consequently hit hard with the KBW banks index making new lows on Friday (KBW some 30% lower on the month) before bouncing with headlines that Yellen had convened a meeting with the Financial Stability Oversight Council (FSOC) to discuss the on-going banking crisis (little emerged from the meeting other than usual sound bites.)
“The banking system remains sound, continue to monitor,” etc etc. (You can feel the unease at this point!)
First Republic Bank stock continues to plumb new lows and looks increasingly in need of a rescue, despite last week's $30bn deposit injection from the big US banks. Meanwhile, back in Europe, despite best efforts from Lagarde and officials to reassure on the soundness and stability of Europe’s banks, Deutsche Bank saw its Credit Default Swaps (CDS) spike higher and share price drop 15% on Friday as the contagion rotates. What a mess 😬.
Fed “one and done”
Amidst all this, the data highlight came from the Fed with its FOMC policy rate decision on Wednesday. The Fed hiked 25bps (to a 4.75% to 5% range) as largely expected into the meeting, after rates whipsawed from 50bps to zero over the past two weeks. But, in a dovish twist, the statement that “ongoing increases in the target range will be appropriate” was replaced with “some additional firming may be appropriate”.
This is as close to announcing a pause as the Fed will give you. The terminal rate forecast was unchanged at 5.1% (Vs. expectations it would be raised to 5.4%). Whilst trying to reassure on the soundness of the banking system, Powell highlighted how the tightening in credit conditions due to the banking volatility was doing the Fed’s job and could be considered as the “firming” required to bring inflation to target. Powell dismissed the notion that rates would be cut, as markets are subsequently pricing.
What does all of this mean?
JPow and the Fed at this point, have lost control of the narrative and lost control of the policy. Markets are back in the driving seat and will dictate policy from here. Indeed, despite the 25bp hike, yields continued to come lower with 2yr yields falling from 4.16% to as low as 3.56% on Friday. 10yr yields similarly from 3.55% to lows of 3.28%.
The market is now pricing a pause in May and 25bps of cuts at the following 5 meetings to bring Fed funds rate back to 3.50-3.75% by year-end. This is a MASSIVE move in front-end rates and suggests a market pricing a full-blown recession as the banking crisis hits main street.
With banks struggling to shore up balance sheets, a credit crunch will see bank lending freeze and accelerate the slowdown that was already underway. A banking crisis, consequently, is super deflationary. As a result, 5yr inflation breakevens are back at 2.25% down from 2.7% at the start of March and likely to keep heading lowe
Interestingly, Trueflation, a blockchain company that delivers daily, real-time, unadjusted inflation data from 10mio data points, saw inflation fall sub 4% on Friday. The “peak inflation” narrative that we’ve been advocating into 2023 is playing out and this is before the current banking crisis. Fed rates at 4.75% are already “restrictive” above real time inflation rates and have room to come lower. Powell on Wednesday also re-emphasized his view that the disinflation process was underway. The data I suspect will start to give him more flexibility to focus on the priority right now - financial stability - and get rates lower.
Flooding liquidity 🌊
As discussed in the previous Macro Pulse “The End Game,” the fiat banking system simply can’t handle high rates without things breaking, and we’ve now reached a breakpoint. Deposits are flooding out of banks in search of higher money market yields. The Fed’s hike on Wednesday will accelerate that move. The liquidity measures such as the BTFP only act to treat the symptoms but not the cause of the issues in the banking systems, which is simply, Fed rates are too high.
Consequently, the Fed will continue to need to provide liquidity to the banking system to prevent its collapse, which will see the Fed balance sheet explode, and this is exactly what we’re seeing.
In the past week, the Fed balance sheet expanded an additional $98bn taking the expansion over two weeks to just under $400bn. This unwinds around 60% of the quantitative tightening of the past year. Furthermore, the use of the BTFP stepped up $43bn this week taking the total use of this facility to $54bn now. A clear demonstration that banks continue to struggle to meet deposit outflows.
I entered 2023 bullish crypto with an expectation that rates would peak as the Fed paused and liquidity would “ease.” That process was broadly playing out. The PBOC and BoJ balance sheet expansion was outpacing the Fed and ECB contraction. Rates were the “missing piece of the puzzle” as we presciently named our March 7th Newsletter. However, 10yr yields did peak in October and the Fed’s blind hawkish rhetoric driving 2yr yields higher could not materially impact the back end of the curve as growth concerns began to outweigh inflation.
Now we’ve seen rates start to fall sharply with the market pricing rate cuts in the second half of this year. The Fed and ECB balance sheets are also back in expansion mode. This is the bullish thesis, but on steroids.
Bitcoin is up circa 35% over the past two weeks, but ran into resistance ahead of 29k which saw some profit taking, although given the moves, the pullback remains shallow and price action constructive.
Crypto-specific newsflow remains negative as the US continues to adopt an anti-crypto stance. Most notably this past week, the SEC issued a Wells notice to Coinbase focused on staking and asset listings. CEO Brian Armstrong’s excellent twitter response which demonstrates how they tried to work transparently with the SEC sets up for a court battle which, if the recent Ripple hearing is to go by, will likely damage what little credibility the SEC have at this point. It may also help force some much-needed transparency and for the SEC to actually provide a regulatory framework that crypto firms can follow—the SEC also issued an “investor alert” urging investors to express caution when investing in digital assets. Irony is not lost on the SEC when their fiat world is blowing up with depositors still at risk!
Nonetheless, these headlines are unhelpful and take a shine off what is a powerful macro narrative for Crypto as the fiat system once again implodes and will need to hook itself up to the intravenous drip of Fed liquidity.
As US banking on-ramps are also shuttered, spot liquidity remains thin as we discussed on the recent TBP podcast (Binance halting spot trading to fix a bug on Friday not helping!) This excellent chart from Kaiko shows how spot liquidity has been in decline since the FTX collapse👇
This lack of spot liquidity may actually exacerbate some explosive moves higher if dealer short gamma exposure is forced to chase the moves higher. Indeed, there’s an interesting dynamic at play right now, whereby, given the positive spot/vol correlation, any spot moves lower on these price pull backs see funds “buy the dip” and re-initiate topside positions, which in turn causes short dealer gamma to expand. We saw this dynamic at play post-FOMC, where clients used the dip to put on 31 March 29k and 30k Calls.
Broadly, we continue to see stronger demand for BTC call spreads due to the now elevated upside skew (25 delta skew currently trades circa 3-4 vols for Calls over Puts) which we expect to continue given the strong upside realized vol and the developing “digital gold” narrative.
To give an idea of bullish price targets, we saw 2150x 26-May 32k/36k call spreads and 1050x 7-April 33k/38k call spreads bought. The flow dynamic supports our bullish thesis.
ETH has been relatively sidelined as BTC is perhaps the “cleanest” play on the implosion of the fiat monetary system (as well as the SEC labeling everything but BTC a security!) Nonetheless, we’re starting to see increasing interest to put on topside ETH, with 20k ETH of bullish risk reversals (28-April 1600/2100 and 1700/2200) bought on Thursday.
Nothing in our flows then to think the bullish sentiment is reversing, despite Friday’s consolidation lower.
Heading into the last week of March, banking stress will continue to dominate, and it’s difficult to see what alleviates the stresses until the Fed cuts rates. So expect further rotating contagion and more liquidity provision. Whilst headlines of another bank failure can weigh on broad risk and crypto short term, ultimately, the authorities have little choice than to back stop the system, flood it with liquidity and debase fiat currency.
With the liquidity taps back on, rate hike cycles ending, there’s a powerful tailwind to crypto. This bull is just getting started. 🚀
David Brickell 💜