Week In Review: The Fed has painted itself into a corner
Who would want Jerome Powell’s job right now?
Last week, we saw further pain in the banking sector as Silicon Valley Bank filed Chapter 11, Signature Bank was seized by regulators, and First Republic got a quasi-rescue. The interesting this about the bank failures this time around was that there was no interest from buyers. In the crisis of 2008, the government engineered a rescue by telling the big banks JP Morgan, Bank of America, Wells Fargo and Citi to buy up Bear Stearns, Washington Mutual, Countrywide, Merrill Lynch, etc. This is historically how governments handle these things. And that probably would have happened this time around except for the fact that the government punished these buyers for their good deeds during the Obama administration. JP Morgan did the government a favor, and got fined over Bear’s sins. Jamie Dimon ran Morgan back then, and I am sure he had a “fool me once” outlook on partnering with Washington. Can’t say I blame him.
So, nobody stepped up to buy Silicon Valley Bank (though HSBC did buy the UK ops), or Signature, and First Republic’s rescue was a commitment from a consortium of banks to deposit money there. New York Community Bank will buy some of Signature’s deposits, but that is it. We know the government wanted these banks bought, so this has to be an embarrassment for the Administration.
It is interesting as well that the FDIC is basically covering all deposits now, not just under $250k. The theory for not guaranteeing all deposits was based on the idea that small investors would be incapable of judging a bank’s creditworthiness, however big depositors don’t need that protection. So much for that theory. These were tech companies with hundreds of millions of dollars, so they probably were sophisticated investors or had access to sophisticated advisors. Ultimately this was a bail out of Silicon Valley, and from now on, the size of the deposit is irrelevant - the government will cover any losses.
The banking problems are not limited to the United States. The Swiss Government engineered a shotgun wedding between Credit Suisse and UBS. UBS will buy its rival for less than half of its closing price on Friday. There will be no shareholder vote and the Swiss National Bank will extend $100 billion in credit and will absorb some of the credit losses if need be.
The result of all the banking chaos has been to blow out mortgage backed security spreads. Mortgage backed securities spreads catch the relative performance of mortgage backed securities MBS spreads were wide for most of 2022, although they narrowed somewhat in late November and December when a couple tame CPI reports convinced the markets the Fed was just about done. MBS spreads are back to November levels which were the widest since 2008.
The corollary of wider MBS spreads is a restriction of mortgage credit. Even before these banking issues mortgage credit availability was the lowest in 10 years, according to the Mortgage Bankers Association Mortgage Credit Availability Index. Who knows what the impact the banking issues will have MBS pricing, but the entire asset class is under a cloud at the moment, and if a bunch of banks are lugging RMBS portfolios and need to unload paper, sentiment will remain bad. This is why the 10 year has dropped about 50 bps in yield over the past couple weeks and the 30 year fixed rate mortgage is down only 9 bps. Mortgage REIT heavyweight, Annaly Capital Management decided to cut its dividend by 26% last week which probably says everything you need to know about the MBS sector. Mortgage bankers hoping that this crisis would push down mortgage rates might be disappointed.
The big question is how this will affect the Fed’s thinking. It is worth noting that the Fed has exactly the same portfolio of highly levered assets that Silicon Valley Bank did - deep out of the money RMBS and low coupon Treasuries. It is what they bought in QE since 2008. The last time they tried to let their portfolio run off, they blew up the repo market. This time, they blew up a couple regional banks. Below is a chart of the Fed’s assets since before the Great Recession. In December of 2007. the Fed had $908 billion of assets. Today, the number is $8.6 trillion. Each time the Fed has tried to reduce its balance sheet, something breaks. And the quickest way to end the pain in the financial sector is to stop hiking rates and start cutting them.
Larry Summers appeared on Bloomberg TV last week, and since the Fed is in the quiet period, he was probably given the job of telling the markets what the Fed is going to do next week. Why Summers to deliver the message and not Yellen? Staying in one’s lane. Treasury doesn’t interfere with the Fed’s messaging on interest rates, and the Fed doesn’t interfere with Treasury’s messaging on the currency. He did acknowledge that this banking crisis will have the same effect as a tightening, so the Fed should take that into account. He said that 50 basis points was probably off the table, however not hiking would send the wrong message. So 25 it is. The Fed Funds futures see another 25 bps hike in March and a cut by the June meeting.
Will this crisis act like a deflationary shock to the economy? Banking crises generally do. This one might be different simply because the assets that are getting people in trouble are Treasuries and mortgage backed securities. These securities are money good. They might have fallen in value, but at the end of the day there is no question that you will get your principal and interest. Banking crisis have usually been driven by credit losses. Aside from a few Chapter 11 filings in the commercial mortgage backed security space, credit is in decent shape. At least so far.
Will the banking crisis help lower inflation? I think the answer is probably no. The strength in the labor market is reaches into just about every sector except for mortgage banking and some tech. Most businesses couldn’t care less about liquidity problems at VC firms on Sand Hill Road. And since wages are the big driver of inflation, I don’t see much change there. It probably won’t affect consumption much at all - nobody is going to cancel their cruise because Facebook laid of a bunch of people.
The Fed (and global central banks in general) have painted themselves into a corner. Raising rates have blown up parts of the banking sector and they are playing with fire if they keep hiking. On the other hand, the labor market remains tight as a drum and workers are in the driver’s seat. The Fed was hoping to get unemployment up around 5%. That doesn’t appear to be in the cards. The Fed is probably going to have to start easing despite bad inflation numbers, and there is not a damn thing they can do about it.
Think about this: Treasuries have fallen far enough to blow some holes in banking balance sheets, and real interest rates are still negative. Sovereign Debt is wildly overvalued and valuations are still in bubble territory.