Everything Is Fine Until It Isn’t

Everything Is Fine Until It Isn’t

Banks had a spot of trouble and the federales responded. Can we get back to pushing stocks up, or is there more to worry about? It’s probably not a surprise to anyone, but I think there’s plenty to worry about. Shocking a levered system with a historic pace of rate hikes isn’t painless.

There are a lot of implications, here. The fundamental problems haven’t been solved. Deposits can continue walking out the door, both because it gets paid better, elsewhere, and now insolvency fears have risen. Toxic assets (which includes high quality bonds with overly low coupons) are still toxic. The Fed facility just allows the bank to have liquidity. It basically helps create zombie banks ala Japan (admittedly on a smaller scale) while they hope the bad assets resolve themselves by going higher, they get bought, or they recapitalize (most likely.) What can quickly solve bank problems with both assets and liabilities?

Regional banks are the ones that are really getting hit by deposit outflows. When deposits leave, lending contracts. That particularly hurts small business and employment. The stock market seems to be in some denial, but the economy is much more likely to get much worse, much sooner than expected. That’s not bullish. Loan destruction is terrible for economic growth.

Some people are celebrating the Fed balance sheet expansion because they don’t understand the that the liquidity model was bound to break eventually, probably once a credit event happens. Well, here we are. This is not a restart of QE. This is massive use of the discount window, more than was used in the 2008 banking crisis (on a dollar basis, not a percentage basis.) It wasn’t good then and it’s not good now. Rapidly expanding loans from distressed banks isn’t stimulative. The fact that it’s happening out of a pretty clear, blue sky, without broad, obvious problems is also pretty concerning

The discount window represents the original function of the Fed as a lender of last resort. It’s lending against collateral at a high rate of interest. Why would anyone do that? They only would under high stress when other banks are too scared to do business with you, which we’ve seen with the elevated FRA-OIS rate, a sign of interbank stress.  Heavy use of the lender of last resort facility is not a good sign. Hopefully we will see the Fed balance sheet come down quickly from here, as that would be a sign that stress in the system is getting better.

The new BTFP facility also saw $12B in usage. It’s a smaller number because there’s a big stigma with using it. You have to be in big trouble to want to use it, as the Fed will investigate what’s going on, and you risk your name could get leaked.

Both cases involve banks borrowing at about 4.75% and lending at about 2.5% (BTFP has better terms, because instead of a haircut, there’s an anti-haircut, as you get a loan at par value of the bond.) That’s not about levering up, that’s about surviving in the hopes you can escape becoming a zombie bank and recapitalize eventually. It’s likely due to heavy deposit flight.

Looks like FDIC usage also went up $143B. That’s another collateralized, emergency problem.  These programs are all going to severely cut earnings at the banks that are using them. Using these facilities cuts credit creation, historically. Why is this not a restart of QE? QE involves buying securities, but all these programs are loans, so all they do is protect asset values, not stimulate lending like QE did. The Fed is uninterested in having QE and spiking inflation. They wouldn’t mind protecting banks while continuing to hike rates, though, which is the likely plan, at least until more things break.

This is a crazy time, and there are a lot of different hot takes out there. There’s no long-term cause for celebration out there. We still have capital flight issues (checking rate 0.1%, MM or T-bill rate 4.5%,) too-high inflation, and an economy that’s likely going to slow sharply. This is still a lousy time to play hero. There’s likely to be more credit events in the months to come. That’s basically guaranteed. Just a question of timing and how bad. None of this is good, and too-high inflation makes this much worse than we’ve seen in the last 40 years. The cost of funds for banks is going up, which means NIM is going down.

Ultimately, we’re tightening lending standards, which does not lead to any kind of inflationary QE effect. Credit was already tightening, but now it’s going to be worse. Credit is going to be tough to come by, which is unfortunate, as we’ve already seen an uptick in distress and bankruptcy due to tighter lending. This really ups the odds of a significant economic slowdown, and sooner than expected. I’m starting to wonder how we can prevent that, really.

In conclusion, I was thinking that we were slowly strolling into recession, but this with this bank stress, it’s more like we’re jogging into recession. We should see the full impact of that in April data, which we would start to see mostly in the middle of May. Chances are, that data will look pretty bad.

In the meantime, we get to live through the creation of that bad data. A lot of these things take time, but we’re already seeing a spike of bankruptcies and tightening of credit. There are plenty of companies, public and private, that have taken no consideration of these rapid changes into their budgets and models. Cost of capital is going up, and if you’re a unicorn company hoping to lever debt into scale, your model just got a lot worse.

What would make me change my mind? If the Fed pivots this week, that will loosen financial conditions and spur inflation. In general, could the Fed change the rules and more broadly socialize losses? We’d have other, worse problems then, though. We’d go from worrying about what’s essentially aggressive deflation to worrying about aggressive inflation. We are hedging for that possibility, but it’s not our base case.

Could we see bank resolutions, forced or otherwise? Sure. Forced mergers aren’t great, as presumably there are haircuts involved. Could smaller banks get picked up by bigger ones? Maybe, but regulators have been reluctant to allow big banks to get bigger, and those losses on smaller banks’ balance sheets make them fairly unattractive.

Right now, investors seem to be taking the lessons of the last 12 years and anticipating the inevitable Fed bailout. Banks are under stress, so the Fed will pivot. The Fed balance sheet is expanding, so money must be going into the market, so buy ARKK. The last 12 years taught people nothing about the valleys of market movements, because they never lasted. Investing like it’s 2020 is awfully dangerous while financial conditions are likely to be tightening rapidly. This is likely to remain volatile, but chances are that many investors are going to learn some awfully tough lessons in the months ahead. Looking at the chart above, is this 2008 or 2020? To me, the red line says 2008.

Addendum: I try to keep these reasonably short, but I have to address the mess with Credit Suisse (CS.) In brief, CS was ‘saved’ by UBS, a healthier, large Swiss bank. Equity was severely hit, and AT1 bonds were wiped out. People are celebrating the Fed providing US dollar swap lines as a sign the Fed has panicked and QE is imminent. I remain of the opinion that is not the case, and the Fed will hike rates on Wednesday, however badly other people may want that to be different. I expect we will get there eventually, but providing liquidity does not preserve solvency. Being to early in expecting a pivot can be a painful experience. Ripple effects seem likely.

At some point, I have to publish this. It’s a very fluid situation, but right now the dollar is up, and the Japanese market is down. It wouldn’t be shocking to have a temporary celebration on having an immediate crisis averted, but right now, markets don’t look very celebratory.