What’s it mean to be stuck between a rock and a hard place? Ask the Fed!
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Certain banks are teetering, and the world has an inflation problem. This is the conundrum currently facing the Federal Reserve as well as other Central Banks around the world. Within the past 2 weeks, we’ve witnessed 3 bank failures (Silvergate, Silicon Valley Bank, and Signature Bank) as well as two engineered rescue packages specifically, Credit Suisse and First Republic.
Why is this happening suddenly?
The catalyst of this episode was the failed attempt by Silicon Valley Bank to sell stock to raise cash to cover losses on its bond portfolio. Traditional banking borrows short-term often in the form of an interest rate paid to depositors and lends longer-term.
Since the shorter-term borrowing is callable by the depositors who are now seeking a higher rate (due to the fact that interest rates have risen rapidly over the past year), and the lending is longer-term as would be the case when a bank buys longer-dated treasury securities and other fixed income securities whose prices decline when interest rates rise, certain banks were forced to sell their long-dated fixed income holdings at a loss in an effort to raise cash to meet withdrawal requests from depositors. In the case of Silicon Valley Bank, this mismatch caused nearly $2 Billion of losses and precipitated the failed attempt to sell SVB stock to plug the hole.
This awakened a fear amongst depositors and shareholders that other banks may be suffering a similar fate of holding securities with mark to market losses against a deposit base that can flee at any moment.
The veil between stability and instability is a lot thinner than many recognize and often held together by mere psychological perception. Deposit holders have an asymmetric payoff for assuming stress associated with anything less than the perceived highest quality banking institution. When I consider my own holdings at various banks, I ask myself, what is my upside for keeping balances at banks that are rumored to have stability issues? I am not being paid more in the form of interest to assume the additional risk and aggravation of holding deposits at one banking institution over another so, why would I want to take that risk?
Even if I felt comfortable that the US Government will backstop my dollar deposits, what do I need that aggravation for especially since I receive no additional upside for assuming the anxiety and perceived delays associated with accessing my money?
It is this calculus that is happening across millions of depositors across the country and across the world that potentially creates the vicious cycle that the regulators are rushing to quell.
Concurrently with this current banking crisis, the world has an inflation problem to contend with. Merely a few weeks ago, economic statistics around the world had been showing signs that inflation is a lot stickier than many anticipated. Just yesterday, Britain’s inflation rate jumped from +10.1% to +10.4% on an annualized basis.
Other inflationary indicators both in the US and around the globe have been showing signs of surprising strength. This leaves policymakers in a conundrum. On the one hand, the rapid raise of interest rates has precipitated a flight of deposits from banks to higher yielding instruments such as short-term treasury securities and money market funds forcing banking institutions to race to raise liquidity to meet these outflows.
On the other hand, due to the persistent inflation problem, central banks were only recently suggesting “higher and for longer” with respect to overnight rates. Many macro hedge funds got blindsided by this collision between the higher for longer short-term rate indications versus the rapid crisis that quickly unfolded within the banking system. The US 2-year note had the largest and fastest move lower in yields since the 1987 stock market crash. The moves in rates due to this collision of factors has been historic.
So, the Fed faces a conundrum.
I believe the stability of the banks and the stability of the global financial system is tantamount to the inflation fight in the eyes of the Fed and other central bankers. They simply cannot precipitate a banking crisis under any circumstances. As a result, they are handicapped in their fight against inflation. This likely means that inflation becomes more entrenched and imbedded in the system.
Under the scenario whereby the central banks are handcuffed, the yield curve steepens with the long-end of the curve underperforming the short-end of the curve since the Central Bank cannot raise rates as quickly or as high as they would like. We’ve witnessed some substantial curve steepening since this episode began. I would expect gold to rally, as we’ve seen. I would expect stocks to fall as fears of banking contagion persist as well as tighter credit conditions and bank lending reducing the availability of credit and halting the flow of growth capital.
As much as the Fed and other central banks would like to take up the fight against inflation, they will be forced to insure the stability of the banking system and the global financial system as their highest priority if and until the storm passes.
This is the season for macro strategies. While there have been some well-known and high-profile losses experienced within the macro and CTA universe during the current month of March due to the rapid onset of the banking crisis, I believe that once this bout of chaos and choppiness abates, the market will absorb the likely course of action and trends will smoothen out. The seeds are being sewn for some large and extended moves in financial markets which is precisely the type of condition necessary for macro managers who are left standing to capitalize upon those moves in a very material manner.
Our multi-Manager Funds have some appropriately sized macro allocation, and the current plan is to re-up our allocation to the strategy over the near-term to insure that we have our desired exposure to the space as a percentage of our overall pool. The return stream of macro is inherently volatile with potentially high return expectancy justifying the level of volatility if done right. We must consider the potential volatility of this return stream as we seek to size the strategy appropriately in the context of the smooth and steady nature which has been the hallmark of the Eagle’s View multi-Manager Funds since their inception.
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Written by Neal Berger
What’s it mean to be stuck between a rock and a hard place? Ask the Fed!
