The Fed-induced Financial Crisis

Markets have been roiled over the last few days by heightened concern with the financial stability of some banks, which led to a “run on the banks” and the need for government bailouts and backstopping. One can attempt to analyze what led to the current crisis and where it leads us, but to answer the latter part of the question, we must first understand the root of the problem.

As we wrote in our analysis pieces in July and October 2022, the Fed and its missteps continued to be at the center of the current crisis:

1. The Fed followed a very accommodative monetary regime for way too long, failing to realize that the liquidity and expansionary fiscal policies could generate an inflationary bubble.
2. The Fed extended its monetary intervention from the front end of the curve via Fed Funds to the entire curve via quantitative easing (“QE”), thus depriving economic and market forces of their normal roles of affecting long-term interest rates based on economic and financial conditions; in particular, long-term rates were kept artificially low (bond prices were expensive)
3. The Fed failed to realize that we were facing a structural shift away from globalization (deglobalization) with its long-term and lasting inflationary effect.
4. Caught in its complacency, and the false narrative of “transitory” inflation, they had sprung into action too late which required more aggressive moves that markets were not prepared for; Covid served as a smoke screen, delaying the Fed realization that we were going through a structural change and persistent inflation.
5. Once the Fed started its rate increases, their rate path was clouded by false predictions, first expecting only modest increases, and later attempting to prepare the markets in advance to precisely the next move with limited success; one can summarize the Fed behavior as first acting too little, too late, and later talking too much.
   
   

While the Fed and its actions are in the root of the current financial crisis, the situation has been amplified by poor management and complacency by some actors in the banking sector. Faced with a prolonged period of zero interest rates, they tried to generate incremental returns by buying longer term government bonds. The fact that the Fed was engaged in QE gave some assurance and comfort to their actions. However, they failed to realize that the Fed actions contributed to long-term rates being lower (bond prices more expensive) than free market behavior would have dictated. Sitting on a mountain of highly priced fixed income instruments, they were fixated on the Fed narrative and failed to see the thickening clouds of rising inflation. Rather than hedge their exposure or shorten their portfolio duration, they were complacent in hoping for a moderate interest rate increase. When they woke up to the reality of inflation, and what the Fed needed to do to address it, they found themselves underwater with significant unrealized losses. As long as their deposits were stable, they could keep their portfolios and not realize the losses.  But once deposits started to decline, they were forced to sell some of their losing portfolios, triggering a “run on the bank” crisis.

The drying up of Covid-related cash programs, poor performance of equities and negative inflation-adjusted returns on deposits forced some households and companies to draw on their deposits, contributing to the crisis. The above scenario was true particularly for the regional banks and other banks concentrating in one sector (like startups or crypto), with less effect on the major banks.

Some market participants were quick to draw parallels between the current crisis and 2008, which we believe is exaggerated. The problem seems to be much more isolated and received excessive attention due to the quick dissemination of information and rumors via the media, as well as the fact that with internet access to accounts a “run on the bank” became a virtual run. In addition, the major banks are in much stronger financial condition than in 2008 and regulators have learned the lesson of the need for a quick response to avert a contagious effect.  We believe that this is an isolated case which is not likely to have a major and lasting effect on the financial system or the economy and, thus, one should focus on the factors we outlined in our October 2022 comment entitled “The Inflation Riddle” for clues as what we should expect going forward.

The main factor going forward is persistent inflation and the likely extended period of high interest rates to address it. Absent a deep recession, which we do not expect due to the ample liquidity that still exists in the financial system, the Fed is likely to raise rates further and keep them there to offset and balance the many years of too accommodative monetary policies and the continuing expansionary fiscal policies. Markets seem to focus on the rapid pace of the Fed’s recent moves, but those were solely due to their previous mistakes. Now that monetary policy is more in line with the Fed’s long-term mandate of keeping inflation under control, the adverse effects of rapid rate hikes should be behind us, and significant dislocations should be limited. As written before, the inflationary effect of deglobalization, the aftermath of Covid, and the dislocation it created in the job markets and its effect on higher wages, along with the fact that companies feel they can raise prices, all point to continuing elevated inflation levels.

Structural shifts, like the one we are currently experiencing, normally give rise to Global Macro trading opportunities as we witnessed in 2022. Within these shifts some cyclical changes may occur, accompanied at times by heightened volatility and abrupt price reversals. While such occurrences may inflict short-term pain, they usually revert to the bigger picture opportunities.

The financial crisis presents a big dilemma for the Fed. On one hand, the persistent inflation requires them to be vigilant and continue with their tightening path. Yet, the financial crisis required them to inject considerable liquidity to avert a more serious banking crisis. The Fed can pursue both goals, but it means that their inflation fight will take longer. These conflicting factors will most likely result in further volatility which we believe can provide global macro trading opportunities.