Edge of the Edge
Edge of the Edge

Edge of the Edge

The simplest thing that can be said about current financial market and banking conditions is this: the unwinding of this Fed-induced, yield-seeking speculative bubble is proceeding as one would expect, and it’s not over by a longshot. (View Highlight)

In contrast, a great deal of market capitalization that passive investors count as “wealth” will likely evaporate, possibly including steep losses to bank shareholders and unsecured bondholders. Investors and policy-makers have confused speculation and extreme valuations with “wealth creation,” but it never was. (View Highlight)

In recent weeks, Silicon Valley Bank became the second-largest bank failure in U.S. history, second to the 2008 failure of Washington Mutual. Yet the bank appeared to be quite stable even at the beginning of this year. Indeed, in its most recent financial report as of December 31, 2022, deposits represented 82% of Silicon Valley Bank’s liabilities, and over 60% of those deposits were invested in cash or government securities. Silicon Valley Bank’s report noted “continued strong capital, with all capital ratios considered ‘well capitalized’ under banking regulations.” What went wrong? The short answer is 1) the bank’s assets suffered large, unrealized losses in recent quarters; 2) in response to the bank’s announcement that it was taking steps to raise more capital, depositors rushed to withdraw their money in a classic bank run; 3) the bank was unable to accommodate the withdrawals, causing the bank to fail due to inadequate liquidity and insolvency. (View Highlight)

he essential ingredients of recent bank strains involve excess bank deposits, well beyond FDIC insurance limits, coupled with losses in the asset holdings of banks, particularly in securities like long-term Treasury bonds that are ordinarily considered “safe.” Silicon Valley Bank did not have enough liquidity to tolerate a bank run, and it did not have adequate solvency to qualify for emergency loans. But emphatically, the failure did not occur because there is too little liquidity in the banking system as a whole. It occurred because there is too much. (View Highlight)

All of those holders – investors, banks, pension funds, everybody – reached for yield, driving the equity market to valuations beyond their 1929 and 2000 extremes; driving interest rates to historic lows; driving the risk-premiums on low-grade debt to levels that still provide little margin of safety; encouraging speculative new issues of stock and covenant-lite debt; encouraging Silicon Valley Bank and others to invest their excess deposits in securities that might offer them something more than zero. (View Highlight)

Even as banks like SIVB created a “duration mismatch” by using short-term deposits to finance investments in long-term Treasury securities, they escaped the scrutiny of regulators because “risk-based capital ratios” consider Treasury securities as risk-free, with a risk-weighting of zero. (View Highlight)

As former FDIC Vice-Chair Tom Hoenig observed, “The weakness is the use of risk-weighted capital measures, rather than equity capital measures that take in all assets. Silicon Valley Bank’s 16% risk-weighted capital looked great, but if you include securities with interest rate risk, and losses on them, they only had 5%.” (View Highlight)

When people say the Fed is “pumping money into the economy,” what actually happens is that the Fed buys interest-bearing securities like Treasury bonds from the public, and the Fed pays for the bonds by creating electronic entries called “bank reserves” that back a new bank deposit owned by whoever sold the bonds. The Fed takes interest-bearing securities out of public hands, and replaces them with zero-interest bank deposits backed by newly created “base money.” (We’ll get to the recent practice of paying interest on reserves shortly). (View Highlight)

Once the Fed creates base money, it has to be held by someone in the economy, in the form of base money, until that base money is retired by the Fed. If you try to put your money “into” a security, the seller of that security takes the money right back out. For more than a decade, all those reserves – and associated bank deposits – earned nothing. Zero. Someone had to hold them, and nobody wanted to. (View Highlight)

Discount lending is not “quantitative easing” because the Fed doesn’t actually buy the securities. It just provides short-term liquidity, backed by collateral. That’s notable because many observers have misinterpreted a recent spike in the Federal Reserve’s balance sheet as “QE,” when it is actually discount lending under a new – though legally questionable – program called the Bank Term Funding Program (BTFP) (View Highlight)

Historically, the reserves created by the Fed have earned zero interest. As the Fed creates more zero-interest liquidity, investors respond by seeking yield in other securities, starting with T-bills. The more plentiful zero-interest liquidity, the lower short-term interest rates.  Prior to 2008, the amount of base money never exceeded 16% of GDP. Once the Fed drowned the public with that much zero-interest money, even a few basis points of interest on T-bills became enough to chase yields back to zero. (View Highlight)

Now that the Fed has been forced to raise rates to fight inflation, how has the Fed been able to keep its balance sheet at a ridiculous 33% of GDP and yet hold short-term interest rates above zero? Well, the only way the Fed has been able to lift short-term interest rates away from zero in recent years is by explicitly paying interest to banks (currently 4.65% IORB) on their reserve balances. (View Highlight)

As I’ve noted during previous bubbles, a market collapse is nothing but risk-aversion meeting an inadequate risk-premium; rising yield pressure meeting an inadequate yield. The extreme valuations encouraged by years of deranged Fed policy are unwinding, and based on the gap between prevailing investment valuations and even modest historical norms, it’s not over by a longshot. (View Highlight)

Recall how we got a mortgage bubble in the first place. Following the 2000-2002 market collapse, Alan Greenspan cut short-term interest rates to just 1%, driving investors to search for alternatives that might offer a higher return. They found that alternative in mortgage securities, which provided a “pickup” in yield over and above T-bills, as well as perceived safety, given that U.S. housing prices had never collapsed. (View Highlight)

Indeed, the thing that finally ended the global financial crisis wasn’t Fed heroism, distressed asset purchases, or quantitative easing. It was a change in accounting rule FAS-157 by the Financial Accounting Standards Board in March 2009, which eased “mark to market” standards for banks, eliminating the prospect of widespread bank insolvency by making insolvency opaque. The decade of zero interest rates that followed simply helped banks to recapitalize their balance sheets, funded by paying depositors zero. (View Highlight)

In response to the insolvency of Silicon Valley Bank and Signature Bank, the Federal Deposit Insurance Corporation (FDIC) took them into receivership, wiping out the stockholders and unsecured bondholders. This was, and remains, the correct approach to bank insolvency. (View Highlight)

Even though recent bank failures were smaller than Washington Mutual, the FDIC invoked a provision that treated these banks as “systemically” important, and covered all of the uninsured deposits as well, even those beyond the $250,000 insured limit (which was increased from $100,000 in 2008). Any losses to the FDIC will be recovered by insurance fees from the banking industry. (View Highlight)

The FDIC only needed to do this because the Federal Reserve bloated the banking system with deposits far beyond any amount required for sound lending, and far beyond FDIC insurance limits. (View Highlight)

Given that money market funds actually do pass the interest they receive from the Fed to their investors, it should be no surprise that depositors have been fleeing the banking system in preference for money market funds. Since the Fed can’t legally pay interest to money market funds directly, it pays “synthetic” interest to money market funds by selling them Treasury securities overnight, and buying them back the next morning at an ever-so-slightly higher price. These transactions are called “overnight reverse repurchases” or ON-RRP. (View Highlight)

In my view, until the Fed normalizes its balance sheet, it may be best for the FDIC to insure all deposits, to promptly take receivership of failing banks, and to charge the banking system insurance premiums sufficient to cover any losses. It isn’t the fault of savers that the banking system is stuffed with excess deposits. Savers, in aggregate, are captive victims, like James Caan in Misery, and the Federal Reserve is Kathy Bates. (View Highlight)

Given that the Fed has created $8 trillion in liabilities, someone has to hold them either: 1) indirectly as bank deposits, where your bank earns 4.65% interest from the Fed on the reserves that back your deposit, and thanks you for being part of its profitable “zero-interest deposit franchise”; 2) indirectly in a money market fund, where the money market fund receives “interest” on ON-RRP transactions with the Fed, or; 3) directly as currency you just pulled out of the ATM. (View Highlight)

The Fed created a mountain of liabilities, and someone has to hold them. Whenever someone waxes rhapsodic about all the “cash on the sidelines” waiting to “go into” some other market, they’re basically telling you they haven’t learned how equilibrium works. Every security that’s issued, even base money, must be held by someone until it is retired. (View Highlight)

As for bank failures, remember that when a bank becomes insolvent, the assets don’t vanish, nor do the bank deposits of customers. What actually happens is that the bank goes into receivership (rather than bankruptcy) with a nearly immediate “purchase and assumption” where another bank takes on all of the insolvent bank’s FDIC insured deposit liabilities, along with some of the assets and a cash payment from the FDIC. (View Highlight)

“The only reason that bank ‘failures’ in the Depression (and the ‘failure’ of Lehman) were problematic is that the institutions had to be liquidated in a disorganized, piecemeal fashion, because there was no receivership and resolution authority that could cut away the operating entity and sell it as a ‘whole bank’ entity ex-bondholder and -stockholder liabilities. I put ‘failure’ in quotations because there is a tendency to think of such events as something to be avoided even at the cost of public funds.” (View Highlight)

Not to be left out of any opportunity to don a flowy cape and nylon tights, the Federal Reserve has responded with its own Bank Term Funding Program (BTFP), offering loans to banks for up to one year, secured by government-backed collateral such as Treasury and mortgage bonds. The terms say “these assets will be valued at par,” presumably even if their market value is well below par. (View Highlight)

Still, one of the lessons of the 2008-2009 global financial crisis is that even after the Treasury and the Fed decided to bail out bank stockholders and bondholders, neither lower interest rates, nor distressed asset purchases, nor quantitative easing were enough to do the trick. (View Highlight)

Instead, the crisis was ended by suspending FAS157 mark-to-market rules. Suspending mark-to-market was at least easier to justify in that crisis because the distressed assets were illiquid securities like collateralized mortgage obligations (CMOs) and hard-to-value sub-prime obligations. Now the Fed has evidently decided to do the same with highly liquid and readily-valued Treasury debt. (View Highlight)

One is reminded that a key feature of Ponzi schemes is that withdrawals by early investors are financed with other people’s money, rather than by sound assets. They work only because the accounting is fraudulent, so nobody realizes that the scheme is insolvent. Since 2008, the Fed has become so comfortable with loose collateral requirements (including treating unsecured junk bonds as their own collateral) that Ponzi finance has apparently become standard operating procedure. (View Highlight)

Shrinking the balance sheet may seem like heresy, but only if one doesn’t understand that interest-bearing reserves are functionally different than zero-interest reserves. (View Highlight)

It was about flooding the financial system with zero-interest reserves. When you force the economy to choke down 36% of GDP in zero-interest reserves, and someone has to hold them, it prompts all sorts of ridiculous speculation, which culminated in early 2022. That’s not “stimulus” – it’s bald-faced speculative distortion. (View Highlight)

The reserves created by the Fed currently function as “synthetic” interest-earning securities. But they’re also bloating the banking system with deposits, creating pressure on the FDIC, and threatening small banks with withdrawals and possibly even insolvency. (View Highlight)

The Federal Reserve’s “ample reserves regime” has not only encouraged the most extreme speculative bubble in history, it has created a host of other distortions that now include bank failures. The faster the Fed can wind down its balance sheet the better. Z (View Highlight)

Indeed, since the Fed launched quantitative easing in 2008, commercial bank loans (total commercial, industrial, consumer, and real-estate) have grown at an average annual growth rate of just 3.6% – the slowest rate of any point during the post-war era, and a fraction of the 9.3% pre-QE average. (View Highlight)

When interest rates are zero, a massive balance sheet drives speculation. Once the reserves created by the Fed pay interest, they become functionally different than zero-interest reserves. They essentially become “synthetic” T-bills. The higher the interest rate, the less they provoke speculation (View Highlight)

If you think commercial banks are the only ones taking losses because of the Federal Reserve’s recklessness, think again. Given that the Federal Reserve now owns about $8 trillion in debt securities, which have declined sharply over the past year and a half, the Fed itself would be insolvent if it marked its assets to market. (View Highlight)

When Jay Powell recently testified to Congress that “We always turn over all of our earnings in every year, and we’ve turned over something like $1.2 trillion dollars just in the last decade or so,” what he failed to say is that an amount far greater than those remittances has been wiped out by capital losses. (View Highlight)

“On the subject of interest rates and inflation, I’ll reiterate that the single best predictor of year-ahead inflation is current year-over-year inflation, and the second-best predictor is last year’s inflation rate. While Fed policy, ISM readings, leading indicators, recessions, unemployment, GDP growth, credit spreads, shipping costs, wage inflation, productivity growth, and countless other measures do affect inflation, in some cases meaningfully, they come in second to prevailing inflation, unless they are extreme – for example, a banking crisis. Otherwise, the tools of monetary policy are quite blunt, and the relationships between Fed policy variables and inflation, or unemployment and inflation, are nowhere near what the public, Wall Street analysts, journalists, and even central bankers seem to believe. (View Highlight)

Inflation basically measures the tradeoff between government liabilities (dollar bills) and real goods and services. The reason inflation is difficult to predict is that it can reflect any combination of four factors: excessive demand for goods and services, constrained supply of goods and services, inadequate demand (lack of confidence) in government liabilities, or excessive supply of government liabilities. Two of those factors are purely psychological. (View Highlight)

Instead, when the Fed needs to respond to inflation, the function of tighter money and systematic policy is to send a signal that the Fed will defend the purchasing power of government liabilities by acting as a brake on their supply. That’s what Paul Volcker did in response to the late-1970’s inflation. He essentially said, look, we’re going to restrict the creation of money, in order to increase your confidence in it. The function of tighter money isn’t to crush the economy with high interest rates, but to restore public confidence that money will hold its purchasing power – by limiting its supply, and in turn, limiting the tendency of Congress to resort to debt finance. (View Highlight)

Notice that a 1% (100 basis point) year-over-year increase in the Fed Funds rate tends to be followed by a slowing of just -0.15% in PCE inflation, with the full effect typically taking 30-36 months, on average. In contrast, a 1% year-over-year change in the unemployment rate tends to be followed by a somewhat larger decline in year-over-year PCE inflation, reaching about -0.35% on average, with a lag of about 9-12 months. (View Highlight)

The main impact of slightly hiking the Fed Funds rate versus holding it steady is in its “signaling” effect. Given that core PCE inflation of 4.7% is well above acceptable levels, while the rate of U.S. unemployment is just 3.6%, pausing the Fed’s response to inflation would essentially convey that the Fed is neither systematic nor serious about price stability, and is likely to flinch and monetize whatever comes its way. That response could easily backfire, sending longer-term yields higher and compounding the unrealized losses of banks on their Treasury holdings. (View Highlight)

As a side note on bond yields, I’ve noted that 10-year Treasury yields have rarely persisted below the weighted average of Treasury bill yields (weight 0.50), year-over-year PCE inflation (0.25), and nominal GDP growth (0.25). Presently, that weighted average is about 5.3%, so the current 10-year Treasury yield of 3.4% embeds quite a bit of confidence that the Fed will achieve its inflation target, whether through recession, credit crisis, or other means. (View Highlight)

Longer-term, investors tend to set 10-year Treasury yields roughly in line with trailing 10-year nominal GDP growth. One might like to think that investors “look ahead” based on expectations of future inflation, but given that the best predictor of future inflation is current inflation, that’s a distinction without a difference. The chart below illustrates this regularity. The current point is shown by the slightly enlarged yellow dot. (View Highlight)

Meanwhile, given the possibility that the Fed will either hike and pause, or pause entirely, it’s worth remembering that the bulk of recession-associated bear markets in the stock market occurred after the Fed pivoted away from further rate hikes. (View Highlight)

Overall, economic risks lean toward a “hard landing,” and a “trap door” is already open in the equity market, but as always, we’ll respond to observable, measurable evidence as it emerges (View Highlight)

We presently estimate that a market loss of -26%, to the 2900 level on the S&P 500, would presently be required simply to restore expected S&P 500 total returns to 3.4%, the present yield of 10-year Treasury bonds. A market loss of -51%, to the 1900 level on the S&P 500, would presently be required to restore a historically normal 5% expected return premium above Treasury bonds (an 8.4% expected nominal total return). Finally, a market loss of -58%, to the 1650 level on the S&P 500, would presently be required to restore historically run-of-the-mill expected returns of 10% annually. (View Highlight)

Overvaluation doesn’t imply an immediate marekt decline. It implies lower long-term returns and deeper full-cycle loss. Our most reliable valuation measures have a strikingly good history of estimating both. (View Highlight)

The distance between the S&P 500 and the green line in the chart above is proportional to our most reliable valuation measure: nonfinancial market capitalization to gross-value added, including estimated foreign revenues. (View Highlight)

With regard to potential market losses over the completion of this market cycle, it’s notable that the trough of a market cycle typically brings expected S&P 500 total returns to the greater of 10% annually or 2% above Treasury bond yields. (View Highlight)

Rather, our discipline is to align our market outlook with measurable, observable market conditions, primarily valuations and market internals (the uniformity or divergence of market action across thousands of individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness). (View Highlight)

We introduced our primary measure of market internals in 1998, with only minor adaptations since. The chart below presents the cumulative total return of the S&P 500 in periods where our measures of market internals have been favorable, accruing Treasury bill interest otherwise. (View Highlight)

Since ragged, divergent internals are typically an indication of risk-aversion among investors, we view the combination of extreme valuations and poor market internals as a “trap door” situation. (View Highlight)