April 10 – Bloomberg (Catarina Saraiva): “Federal Reserve Bank of Chicago President Austan Goolsbee said the US central bank should exercise ‘prudence and patience’ in raising interest rates as policymakers assess just how much last month’s banking turmoil will contribute to tighter lending conditions. ‘Given how uncertainty abounds about where these financial headwinds are going, I think we need to be cautious,’ Goolsbee said in prepared remarks… ‘We should gather further data and be careful about raising rates too aggressively until we see how much work the headwinds are doing for us in getting down inflation.’”
Reasonable enough. With bank lending tightening, it seems prudent for the Fed to hit the pause button. The problem is that markets eagerly anticipate the day the Fed backpedals from its inflation fight at the first sign of instability.
When market instability surfaced early in the summer in 2013, Bernanke reassured markets that the Federal Reserve was prepared to “push back” against tightening financial conditions. When Yellen’s baby-step 25 bps increase off the zero bound rattled markets in December 2015, the Fed waited a full year before the next little one. Powell responded to mid-2019 money market unrest with a “mid-cycle adjustment” rate cut (to 2.00%) and the restart of QE. The Powell Fed then opened the monetary floodgates in March 2020 – and didn’t get rates back above 1% until June 2022.
Understandably, markets are conditioned for loose conditions, expecting Fed loosening measures to reverse any meaningful tightening. The Nasdaq100 sports an almost 20% y-t-d gain. The VIX (equities volatility) Index closed Friday trading at 17.07, the low since January 2022. The rates market currently prices two 25 bps rate cuts between July and December. Despite elevated inflation, 10-year Treasury yields remain at a historically low 3.50%.
I appreciate Austan Goolsbee and others fretting that Fed tightening measures will push the U.S. economy into recession. I take a different view: Post-Bubble recession is both unavoidable and necessary. My worries are elsewhere.
I began warning about the emerging “global government finance Bubble” in 2009, after contemplating the incredible reflationary monetary and fiscal policy responses to the 2008 crisis. I had zero confidence that the right lessons had been learned. Never, however, did I imagine chronicling this Bubble in 2023 – with the Fed’s balance sheet at $8.6 TN and outstanding Treasuries at $27 TN – both having inflated about four-fold.
I worry most about a mounting systemic crisis of confidence in monetary policy, government debt, market structure, and finance more generally. I see hopelessly dysfunctional markets, distorted from years of low rates, interminable liquidity excess, and habitual market interventions and bailouts. I fear a stock market, incapable of adjustment, increasingly vulnerable to dislocation and panic. I see a Treasury market where yields are completely divorced from an unending massive supply of new debt securities. Devoid of market discipline, Washington politicians will continue to bankrupt the country in debt and inflation.
So far, the bank crisis and extraordinary liquidity responses from the Fed and FHLB have spurred a loosening of market financial conditions.
April 10 – Bloomberg (Austin Weinstein): “The Federal Home Loan Bank system issued $37 billion in debt in the last week of March, a sharp drop-off from the $304 billion two weeks earlier… Short-term issuance — notes with terms from one day to one year — fell sharply. It reached a peak of $153 billion for the week ended March 17… That issuance fell to $32.2 billion the next week and then declined to $17.6 billion the week ended March 31… The system’s bond issuance — with durations generally over one year — has also tumbled. The system issued $151 billion in bonds the week after Silicon Valley Bank was put into receivership, $40.1 billion the next week and then $19.8 billion the week ended March 31.”
We’ll have to wait for official data, but we can assume the FHLB boosted loans/advances to member financial institutions (in the neighborhood of) an unprecedented $400 billion in the wake of the SVB collapse. Coupled with Fed lending facilities, it has been another bout of historic liquidity injections.
April 11 – Bloomberg (Austin Weinstein): “Two housing-policy experts whose previous recommendations have been closely followed by the Biden administration are defending the Federal Home Loan Banks, raising the stakes in a debate over whether a major overhaul is needed. The new paper from Jim Parrott and Mark Zandi is an opening salvo in what will likely be a high-stakes battle over the future of the lenders. The FHLB system has come under fire in recent weeks for loans made to now-collapsed financial institutions Silicon Valley Bank, Signature Bank and Silvergate Capital Corp. FHLB loans come with favorable interest rates due to implied US government backing, despite the banks being cooperatives owned by financial institutions. Critics say they can encourage risky behavior by financial firms.”
Jim Parrott (Parrott Ryan Advisors) and Mark Zandi (chief economist at Moody’s Analytics) are seasoned analysts. Their paper, “In Defense of the Federal Home Loan Banks,” is informative, relatively comprehensive, and well-researched.
“Critics contend that the FHLBs distort the financial system by crowding out deposits and depressing deposit rates, relying too heavily on money market funds for their funding, and potentially disrupting the federal funds market. Each of these criticisms is overstated if not misplaced.”
“Critics also argue that the FHLBs can be a source of systemic instability in a crisis. Most recently, they have claimed that the FHLBs’ funding of Silvergate and Silicon Valley Bank shows that the FHLBs’ lack of oversight and restrictions on the use of their advances accelerates rather than mitigates risk in a time of stress. While this concern is not surprising as policymakers work to understand the causes of these failures, it too is misplaced here.”
“It is important to keep in mind that the FHLBs are designed to be a bulwark against instability through the cycle. Their explicit and implicit support from the government reduces the pressure that the system faces in times of stress, keeping the cost of their debt low and stable.”
“If anything, the FHLB system should be expanded to provide that support more broadly and effectively in an ever-changing mortgage market and financial system.”
The FHLB, along with Fannie Mae, was created as part of Washington’s response to the banking collapse and Great Depression. Over recent decades, the GSEs have inflated into massive and powerful lenders and liquidity providers. They have been instrumental players in historic Credit excess – fundamental to the Great Credit Bubble.
A Bubble fueled by risky Credit will generally not pose major systemic risk. I have over the years explained how a Bubble financed by junk bonds wouldn’t get too far out of hand before buyers reached the point of “have enough, no more risky junk!” Such risk aversion would conclude the boom. Importantly, junk bond risks are self-evident, transparency that works to ensure that market dynamics regulate prices and issuance. There can certainly be excess and speculative Bubbles – but not of the dangerously protracted and deeply systemic variety.
Conversely, a Bubble fueled by “money” is a much more threatening animal. With perceived safe and liquid Credit instruments essentially enjoying insatiable demand, money-like Credit instruments are powerful sustenance for prolonged, structure-altering, and deeply systemic Bubbles. When it comes to “money,” risks are well-concealed and amass surreptitiously over years. Many of us innately have demands for as much “money” as we can get our hands on, with this dynamic disabling market processes.
Beginning the year at zero, Silicon Valley Bank borrowed $15 billion from the FHLB in 2022. SVB’s securities portfolio was declining in value last year, while the bank was losing deposits. The environment was turning against the bank. Management should have been reducing the size and risk profile of its securities portfolio, shrinking its balance sheet in preparation for a challenging environment. Instead, they, along with many peers, simply leaned on cheap and readily available FHLB liquidity.
The FHLB was operating as a central bank liquidity backstop, but without the stigma associated with borrowing at the Fed’s discount window. Member bank managements could disregard risky securities portfolios, asset/liability mismatches, and depositor flight risk – confident the FHLB had their backs. If this hasn’t illuminated a perilous market distortion, I don’t know what it will take. More troubling, we’ve witnessed the peril of this type of moral hazard before. Lessons never learned.
The great mortgage finance bubble was initially pierced when two Bear Stearns structured Credit funds began to collapse in June 2007, marking an abrupt end to the subprime mortgage boom. Not coincidently, FHLB “Loans and Advances” (from Z.1) surged $180 billion during Q3 2007, a four-fold increase from its previous record set during the Russia/LTCM crisis period (Q4 1998). And over the four quarters Q3 2007 through Q2 2008, total GSE Assets inflated a record $1.564 TN. Powered by the GSEs, Financial Sector borrowings expanded a record $2.043 TN, or 13.5%, in 2007. Financial Sector borrowings increased $1.745 TN in 2022, by far the strongest expansion since 2007. GSE Assets were up an annual record $921 billion last year to $9.224 TN.
Did 2007’s wild late-cycle Monetary Inflation mitigate or exacerbate systemic risk? From my perspective, clearly it was a factor in the near system collapse that unfolded in late-2008. I’m hard pressed to see how system stability was bolstered by prolonging the boom another year. The sooner a system begins post-Bubble adjustment, the better. And I strongly argue that systemic risk rises parabolically late in the cycle. Prolonging a Bubble an additional year – with associated Monetary Disorder – ensures significantly greater market, financial and economic dislocation. On a micro level, SVB management could have saved the bank in 2022.
Recall that after subprime-related market weakness, the S&P500 rallied 15% off August lows to a record high in October 2007. Moreover, in mid-May 2008, the S&P500 was still above the subprime trading low level and less than 9% below the all-time high. An over-liquefied and highly speculative marketplace was incapable of an orderly adjustment to the collapsing mortgage finance Bubble.
Some Monetary Disorder manifestations were more conspicuous. From late June 2007 to its peak in early-July 2008, the Bloomberg Commodities Index jumped almost 40%. Over this period, crude went on a moonshot, surging from $65 to a July 11, 2008, intraday peak of $147. CPI (y-o-y) reached a 17-year high 5.6% in July 2008. Yet despite surging crude, commodities and consumer price inflation, 10-year Treasury yields were more than 100 bps lower in July 2008 (compared to June 2007).
A prescient bond market discounted the approaching “accident”. Rising bond prices/lower market yields threw gas on destabilizing stock market and commodities speculation. The confluence of massive GSE/Financial Sector liquidity creation and 300 bps of Fed rate cuts prolonged speculative excesses, ending with a near market meltdown – the so-called Great Financial Crisis.
Today’s parabolic phase of the “global government finance Bubble” runs unabated.
April 8 – Reuters (Lindsay Dunsmuir): “The U.S. government recorded a $378-billion budget deficit in March as outlays outpaced revenues… That compared to a budget deficit of $193 billion in the same month last year… Analysts… had forecast a $302 billion deficit for the month. The March deficit brought the year-to-date fiscal deficit to $1.1 trillion, up 65% from a year earlier… Unadjusted receipts last month totaled $313 billion, down 1% from $315 billion in March 2022, while unadjusted outlays were $691 billion, an increase of 36% from the same month a year earlier.”
April 14 – Bloomberg (Silla Brush): “BlackRock Inc.’s assets swelled to $9.09 trillion in the first quarter as depositors sought cover following the collapse of several US banks by pouring money into the firm’s cash-management funds. Net flows into all of the firm’s funds totaled $110 billion…, with investors and clients adding money to bond ETFs. Long-term investment products, which include mutual funds and ETFs, added $103 billion…”
April 14 – Reuters (Harry Robertson): “Investors have moved $538 billion into cash funds over the past eight weeks as they pulled money out of bank deposits after the collapse of Silicon Valley Bank, according to Bank of America… BofA, citing EPFR data, said investors put $51.6 billion into money market funds in the week to Wednesday as the outsized flows continued.”
Money market fund assets surged $384 billion over the past five weeks to a record $5.277 TN, with year-to-date growth of $463 billion, or 42% annualized. In the 15 months leading up to the GFC (June 2007 to September 2008), money fund assets surged $1.055 TN, or 42%.
Extreme inflations of “Money” are perilous. They tend to fuel late-stage Bubble excess and inflation, setting the stage for crises of confidence. Money is perceived as a liquid and stable store of nominal value. As some small and mid-sized banks have recently come to appreciate, instability erupts when risk-averse holders question “money’s” soundness. Exit immediately and ask questions later.
The incredible growth of (perceived safe and liquid) money-like money market funds and ETFs has Fed and GSE fingerprints all over it. A thought on the market pricing a 50 bps lower policy rate by year end: It is not so much that markets believe the Fed will cut rates twice – in response to an economic downturn. It’s more the market pricing in probabilities of the Fed being forced to reverse course – probabilities of an “accident”. Think perhaps of a 50% probability of an accident forcing the Fed to slash rates 100 bps.
European bonds were hit hard this week, with French yields up 31 bps, German 26 bps, and Italian yields 27 bps. At Thursday’s close, 10-year Treasury yields had only increased five bps. It was as if the Treasury market had such market conviction for the “accident” scenario that it could now ignore rising global bond yields and “risk on” equities. Meanwhile, equities were getting pretty excited by the prospect of FOMO (fear of missing out) taking hold without the fear of the stock rally getting slammed by spiking market yields.
With options expiration this coming Friday, the market has again worked its magic to ensure a lot of hedges expire worthless. I’m with the bond market for the possibility of an accident this year. I just believe the odds are higher.
Original Post 15 April 2023
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Categories: Doug Noland