Sunday, March 19, 2023

More thoughts on the banking crisis

By calling into question the value of a significant portion of the country's bank deposits, the recent failure of one or more regional banks is equivalent to a sudden tightening of monetary policy, in which the supply of money is perceived to have contracted while the demand for the remaining portion has increased.

Background: The "ideal" money can be defined as a highly liquid, universally-accepted medium of exchange that holds its value over time and can—but not necessarily—also pay a floating rate of interest, e.g., currency, checking and demand deposits, and retail money market funds. M2 incorporates all of these and is thus an excellent way to track the supply of money.

Therefore, we might say that the current banking crisis is being caused by the perception that some portion of M2 (e.g., bank deposits in regional banks) may lose—or may have already lost—value in the event of a bank failure or expected bank failures. That perception automatically triggers an increased demand for the rest of M2. Together, this has the same effect as a sudden tightening of monetary policy; the supply of money has decreased at the same time the demand for money has increased.

If the Fed does not offset this effective tightening by reducing interest rates, things could get ugly. Reducing interest rates does two things: 1) it makes holding money less attractive on the margin, and 2) it makes borrowing money more attractive on the margin. This serves to reduce the demand for money while at the same time increasing the supply of money (because an increase in loans expands the supply of money). Together they amount to a relaxing of monetary policy, and that is the appropriate response to a sudden and unexpected tightening of monetary policy.

The Federal Open Market Committee (FOMC) meets on Wednesday, March 22, at which time they are expected to make what is now an extremely important decision: will they raise rates, hold rates steady, or cut rates? The market seems to expect they will most likely hold rates steady. I would argue they should cut rates, as my argument above suggests, and I hope they do.

Some helpful charts for background follow:

Chart #1

Chart #1 shows the inflation-adjusted value of the dollar relative to a trade-weighted measure of other currencies. By any measure the dollar is strong, and significantly stronger than it has been for most of the past half-century. Judging by this evidence, the dollar is still the world's premier currency. We could also infer that there is no excess supply of dollars relative to the world's demand for dollars. This further suggests that a sudden tightening of US monetary policy (as described above) could boost the dollar's value further, thus negatively impacting nearly every other currency on the planet. A strong currency is very important, as is a stable currency. A strong and appreciating currency is not necessarily a good thing.

Chart #2

Chart #2 compares the value of the dollar (using a popular but less robust measure of the dollar's value than that used in Chart #2) to the inflation-adjusted price of gold. (Note: I have inverted the dollar, so a falling blue line represents a stronger dollar.) If the dollar and gold were competing "safe ports in a monetary storm" then a stronger dollar might coincide with a lower gold price, and vice versa. That has been the case of many years, as the chart suggests. In recent years, however, the dollar has appreciated alongside a rising gold price. Is the dollar "too strong," or is gold "too strong?" I don't have a good answer to that, unfortunately.

Chart #3

Chart #3 shows the level of the Fed's balance sheet. Last week, the Fed's balance sheet jumped by about $300 billion, the result of the Fed extending credit to troubled banks in exchange for those banks posting notes and bonds as collateral for an emergency loan. Did the supply of money also increase? We won't know the answer to that question until the release of March M2 statistics on April 25th. I would also note that there has been no appreciable shrinkage in the Fed's balance sheet despite their professed intention to do so.

Chart #4

Chart #4 shows the level of bank reserves held on deposit with the Fed by the nation's banks. For decades prior to 2008, bank reserves were only a tiny fraction of what they are today. That's because bank reserves paid no interest prior to 2008, and banks were required to hold reserves in order to collateralize their deposits. Thus, banks held only the absolute minimum amount of reserves they were required to hold. After 2008, the Fed began paying interest on reserves, and so banks came to view reserves as a valuable asset: highest quality, risk-free, default-free, and paying a floating rate of interest. In short, reserves came to be viewed as functionally equivalent to T-bills, and banks were happy to load up on their holdings of reserves. 

By any measure, and from an historical perspective, there is an abundance of bank reserves today. The Fed is not significantly restricting the supply of this very important asset like they did prior to 2008, when the Fed intentionally restricted the supply of reserves in order to boost market interest rates (banks that wanted to expand their lending were forced to borrow reserves from other banks, and that boosted short-term interest rates). That is one good reason to think that the banking system and financial markets today are more resilient than in prior Fed tightenings.

Chart #5

Chart #5 shows the level of 2-yr swap spreads. (See my swap spread primer here.) This is an all-important measure of liquidity in the banking system (the lower the spread the greater the liquidity) as well as the financial health of the economy (the lower the better). Note that in the wake of the SVB crisis, swap spreads have fallen. This dovetails with Chart #5 in the sense that both suggest that there is abundant liquidity in the banking system, and that's a very good thing.

Chart #6

Chart #6 shows the level of Credit Default Swap spreads, which is a very liquid and generic indicator of the market's perception of the health of corporate profits, and by inference the health of the economy. These spreads have risen somewhat in the wake of the SVB crisis, but not significantly, and that's a good thing, since it means the economy is not likely on the cusp of recession.

Chart #7

Chart #7 shows the level of nominal and real 5-yr Treasury yields and the difference between the two, which is the market's expectation for what CPI inflation will average over the next 5 years. By this measure, the market is saying there is almost no problem with the outlook for inflation. Whatever the Fed has done to date has been sufficient to tame the inflation beast that awakened (unexpectedly, for those who have not followed this blog) over a year ago. 

Chart #8

Chart #8 shows the year over year and 6-mo. annualized rate of change in the Producer Price Final Demand index (i.e., inflation at the wholesale level). Both measures have dropped significantly from their peaks of last year. This is a good approximation of what we likely will see happening with the CPI over the course of this year. 


Scott Grannis said...

It should be obvious, but I suppose it's best to make it clear: a significant reduction in interest rates would go a long way to eliminating the problem that sparked this crisis to begin with, namely, that sharply higher rates have depressed the value of notes and bonds held by regional banks. Lower rates will boost bond prices and thus reduce the risk that banks' capital is severely eroded by forced asset sales necessary to meet deposit outflows.

steve said...

The banking crisis is 100% Fed induced. Firstly, by keeping rates at 0% and almost forcing banks to lend during Covid and they did so AND bought longer duration treasuries as Tbills and notes were yielding literally nothing. THEN waiting too long to recognize the problem (inflation) they induced by giving away too much money and finally by jacking up rates from 0 to 5% in record time. It's not that surprising that depositors get nervous over their "safe" money when the banks get to price their investments at cost Vs market. Voila, a crisis!

The Fed has been so dreadfully wrong for so long its a mystery to me that we don't take The greatest economist who ever lived (obviously Milton Friedman) advice and replace them with a computer! Think of the money we'd save not to mention the angst.

steve said...

I would be remiss to add that with the Biden admin practically guaranteeing all uninsured deposits (how many trillions is that?) the obvious collateral risk is mind blowing. Why should banks invest their deposits conservatively when the deposits are guaranteed? What a damn mess.

Duncan said...

It is mind numbing that the Fed would not considering the impact of a 20% reduction in the value of the most ubiquitous collateral (ie US Tbonds) would have on the banking sector. Bankers only have two jobs to manage credit risk and manage duration. The last crisis was over credit risk. This one is shaping up to be one over duration. Hard to imagine rates going up again on Weds.

randy said...

This morning WSJ has an opinion piece that asks you to imagine that, instead of SVB, the regional bank in trouble was in Houston, and served a tight night group in the fracking industry. How likely would it be the Fed would behave the same? Not hard to imagine. The article also highlights how the SVB bailout saves not just the bank but the California economy as well.

steve said...

An absolute MUST read:

steve said...

We live in extraordinarily dangerous financial times and the more the Fed/admin steps in to "Save" us, the worse the risk gets.

Salmo Trutta said...

re: "moving the country in the direction of a national bankruptcy"

Yes, the FED is operating the economic engine in reverse.

Salmo Trutta said...

See: Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?

Grannis is right. But N-gDp is still too high. The FED is doing things backwards. You drop interest rates and drain reserves at the same time. I.e., by driving the banks out of the savings business, you increase the supply of loanable funds, but not the supply of money.

The correct response to stagflation is the 1966 Interest Rate Adjustment Act.

“while the aggregate of time and demand deposits continued to increase after July, the proportion of time to demand deposits diminished. Whereas time deposits were 105 percent of demand deposits in July, by the end of the year, the proportion had fallen to 98 percent. These were all desirable developments.”

M1 peaked @137.2 on 1/1/1966 and didn’t exceed that # until 9/1/1967. Deposit rates of banks decreased from a high range of 5 1/2 to a low range of 4 % (albeit not enough). A .75% interest rate differential was given to the nonbanks.

And during this period, the unemployment rate and inflation rates fell. And real interest rates rose.

Salmo Trutta said...

A universal guarantee on all bank deposits, like during the GFC, will reduce the supply of loan funds, will reduce the transaction’s velocity of funds, will reduce the real rate of interest, and thus will lower R-gDp and raise the Federal Deficit.

The FED’s Ph.Ds. don’t know a debit from a credit, a bank from a nonbank.

Roy said...

It looks like all deposits will be guaranteed and the only way to achieve that is by printing a lot more when banks fail.

That 300B is just the beginning.

Roy said...

S&P is back over 4000 as of this writing. Unless there's a massive drop by the market's close it's pretty much certain they would raise tomorrow by 0.25.

And, if the market likes that and keeps going up, then next time might be 0.5...

Salmo Trutta said...

Powell is dangerous. Powell doesn't know what he's doing. With the Continental Illinois bailout, reserves were "washed out".

DanQ said...

This is excellent. 100% agree. It is amazing to me that the Fed is going to raise rates tomorrow to hit the 4.75-5.00% mark. Looks like 80% probability--see below. The Fed has caused this crisis by leaving rates low for a long time, engaging in substantial quantitative easing, and then jacking rates up at nearly the fastest in history. If one looks at SVB's balance sheet and NIM, it actually expanded from 1.91% in Q4/21 to 2.00% in Q4/22. The pundits are only looking at the Treasury and MBS holdings rather than the entire balance sheet. But no one ever said bank runs and panics have to be rational. It still seems bizarre/dangerous that we are in a situation where MTM accounting is applied to only one part of a bank's balance sheet. Aren't non-interest bearing deposits worth a lot more in a rising rate environment? But none of this matters in a panic and bank run.

As far as inflation, with rates at 4%+, monetary policy is sufficiently tight as you have pointed out in numerous charts and posts. I think one of the things that Jay Powell and the Fed are missing in the inflation fight is the supply side. The pandemic, government shutdowns, and stimulus payments (paid to people to not work) were and are critical components to the inflation. The labor markets and supply chains have gotten much better, but they are still normalizing. We need more people working, not fewer people. Let our remarkable economy do its thing. But Jay Powell apparently thinks increasing unemployment won't hurt the supply chain side of things. He is dead wrong. One example: the sharp spike in interest rates has already caused housing starts and construction to plunge. How does that help to increase housing/shelter supply?

Increasing rates tomorrow in light of all this and the heightened anxiety and bank failures will go down as one of the dumbest moves in the history of central banking. The Fed should have cut rates by 50bp last Monday to stop cold the bank failure contagion in its tracks.

Jim said...

I agree that this is essentially a government incompetency issue, but it is not entirely the FED's. Dodd-Frank over emphasized credit risk and left out duration risk. With deposit insurance there is more incentive to reach for yields. Whatever the government does, it is always rear-view mirror driving and creates new problems. SVB mgt went for risk-safe higher yields but incurred massive duration risk. Then we have ESG and crypto incentives that were not helpful, but that is for another day.

minnesota nice said...

If the Fed increase rates, wouldn't that possible decrease the long term treasuries because of a fear of recession (giving us a deeply inverted yield curve). On the other hand, if the fed decreases rates, wouldn't that be seen (rightly or wrongly) as inflationary and, thus, long term rates would increase?

Benjamin Cole said...

Another great post by Scott Grannis.

BTW, the Cato guy says inflation nearly dead already...we are seeing lag effects of how housing costs are measured...

worth pondering....

Roy said...

minnesota nice,

If the Fed pauses here/cut the market would probably view it as a statement that there's something wrong with the economy and a recession is around the corner.

The Fed is not using Scott's metrics, it uses its own + plenty of politics.

Salmo Trutta said...

@Benjamin Cole:

re: "effects of how housing costs are measured.."

Bankrupt-u-Bernanke caused the GFC all by himself. #1 Bernanke drained legal reserves for 29 contiguous months, turning otherwise safe assets into impaired assets. # Bernanke remunerated IBDDs, destroying the nonbanks. I.e., long-term money flows fell.

Today we have the opposite situation. Long-term money flows are still rising, decelerating, but rising. There's a huge shortage of inventory. Income inequality will accelerate.

2$ inflation is a joke.

Richard H. said...

Hello Salmo, are IBDDs interbank demand deposits? Is that the same as excess reserves, or Federal funds?

Salmo Trutta said...

The same as bank reserves. Remember that "excess reserves" is an accounting concept, not a physical item. The physical item (asset) is deposits at Fed Res Banks

Richard H. said...

Thank you Salmo ... There is one other thing that you say, i.e. "Savers never transfer their savings outside the banks", which I understand on the system wide basis. But by Savings are you including money market funds (in Repo or other)? Does this hinge on whether they are money market accounts (at banks) vs money market funds (not at banks)?

Salmo Trutta said...

MMMFs are intermediaries. Theoretically, they could create money, but in practice they don't.

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, via negotiable credit instruments (or data pathways), and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

Salmo Trutta said...

See: Eric Basmajian

In the week ending March 15th, other deposits at all domestically chartered banks declined by $60 billion.

Other deposit liabilities "ODL" strips out large-time deposits and money market funds.

Other deposits at large banks increased by $65 billion, while other deposits at small banks declined by $125 billion.

Over the last 12 weeks, other deposits at small banks contracted at an unprecedented 16.4% annualized pace.

As deposits flow out of smaller and regional banks, the funds are absorbed by larger banks or money market funds, which drive much less credit creation in the post-2008 period.

Salmo Trutta said...

See the FED's reversal of QT:,drawing%20right%20certificate%20account%2C%22%20and%20%22Treasury%20currency%20outstanding.

Glenn said...

Nouriel Roubini wrote a good article on the debt trap we're now in, due to rising interest rates and the coming liquidity crisis due primarily to the banking crisis due to unrealized losses on treasuries. The feds patched it for now, by not forcing banks to mark to market which is the gold standard of liquidity. So unless banks have mostly 2 year notes and the next crisis doesn't strike before these notes mature, we might get through this mess. But if banks have 5-10+ year notes and/or the next panic hits within a year I don't see how even the fed can pump enough liquidity into the system to stanch a run on banks or stock market collapse from just plain fear. Patience and time could resolve much of this, but when it comes to finances we're all fear mongers. Crises always come from where you don't expect, otherwise we'd prepare for them.

Roy said...

By now it's pretty apparent liquidity has indeed increased.

Going forward, we will have Trump back in the race, which possibly means even more liquidity from the current administration for obvious reasons. This seems even more likely as savings ar drained toward 2H, together with other Covid policies.

I'm not trying to be cynical or even political about it, simply trying to estimate the path forward and how to invest. Headline CPI drops faster than core, so they would focus on headline.

Any thoughts?

Benjamin Cole said...

Worth reading.

Inflation dropping quickly.

Scott Grannis can (again) say, "I told you so."

BTW, I work in SE Asia. Inflation is becoming deflation in parts of Asia.

wkevinw said...

Off-Topic: Deflation in Artificial Intelligence.

AI companies purchased for billions of $? Probably overpaid.