That Was Interesting
Doug Nolan
A quarter that began with The Big Squeeze - only to be interrupted by a banking crisis and intense policy response – concluded with a reemergence of squeeze dynamics.
The Goldman Sachs Short Index jumped 5.1% during the final week of the quarter to end the period with a 7.5% gain.
This index had gained 33% y-t-d at February 2nd highs.
From this high to March 23rd lows, the index dropped 25%.
The Philadelphia Semiconductor (SOX) Index returned 27.6% for the quarter, with the Nasdaq Computer Index up 25.7% and the NYSE Arca Technology Index gaining 26.1%.
The Nasdaq100 (NDX) jumped 20.5%.
Nvidia surged 90%, Meta/Facebook 76%, Tesla 68%, Warner Brothers Discovery 59%, Align Technology 58%, AMD 51%, and Airbnb 46%.
The ARK Innovation ETF returned 29%.
The “average stock” Value Line Arithmetic Index gained 5.8%.
The crypto currencies rocketed higher, with Bitcoin rallying 72% during Q1.
The Nasdaq Bank Index lost 21.9%, and the KBW Bank Index fell 18.7%.
First Republic sank 88.5%, Western Alliance Bancorp 40.3%, Zions 39.1%, Comerica 35.1%, Keycorp 28.1%, Citizens Financial 22.9%, and Huntington Bancshares 20.6%.
Two-year Treasury yields began the year at 4.43% and were down to 4.10% by February 2nd.
Yields then surged almost 100 bps to trade to 5.07% on March 8th.
Volatility went from extraordinary to historic.
Yields were down to 3.71% intraday on the 15th, only to rally back to 4.25% on the 17th.
They sank to a low of 3.63% on the 20th, back up to 4.25% on the 22nd, and then down to 3.55% on the 24th – only to end the quarter at 4.03%.
After beginning the year at 4.92%, market expectations for the “peak” Fed policy rate at the July 26th meeting were up to 5.67% on March 8th.
Expectations then collapsed an incredible 156 bps over three sessions, dropping to 4.11% on the 13th.
Rate expectations then recovered to 4.64% on the 14th, back down to 4.12% on the 15th, up to 4.55% on the 16th, down to 4.20% on the 17th, and back up to 4.73% on the 21st – ending March at 4.83% (down 9bps for the quarter).
Market expectations for the policy rate at the December 13th meeting began the year at 4.59%, surged to a high of 5.56% on March 8th, traded to a March 15th intraday low of 3.40%, and closed the month at 4.35%.
Markets began the year pricing 38 bps of rate cuts between the May 3rd and December 13th FOMC meetings.
By March 8th, this had shifted to 20 bps of additional tightening.
A week later (March 15), markets were pricing 106 bps of rate cuts.
By quarter end, expectations were for rates to drop 39 bps.
Of course, it was not just market prices that turned highly unstable.
Two of the three largest bank failures in U.S. history occurred in March.
Silicon Valley Bank’s stock began the year at $230, with the stock up 50% y-t-d at February 2nd highs – in a brutal short squeeze.
At $271, the stock still enjoyed strong early-2023 gains on March 8th.
The stock dropped to $106 on Thursday, March 9th – before trading was halted.
California regulators took possession of the failing bank that Friday evening.
SVB’s stock opened for trading this Tuesday below a buck.
Signature Bank enjoyed an almost 30% gain at February 2nd highs – and was little changed y-t-d on Monday, March 6th.
It was closed by New York regulators on Sunday March 12th.
So much for stock prices discounting future prospects.
Federal Reserve Credit expanded $391 billion during the final three weeks of the quarter, reversing much of the QT-related contraction that commenced last June.
The Fed lent $180 billion to the FDIC.
Discount window borrowing surged to $110 billion, while the Fed’s new bank lending facility rose to $64 billion.
The Fed’s foreign “repo” lending facility jumped to $55 billion.
Once again, aggressive Fed measures were called upon for system stabilization.
While crisis dynamics were temporarily contained, another blast of monetary inflation is highly destabilizing.
Money Market assets surged a stunning $304 billion in three weeks to a record $5.198 TN.
Money funds were up $384 billion during Q1, posting 32% annualized growth – with one-year expansion of $608 billion, or 13.2%.
Money fund assets are commonly viewed as a system liquidity buffer, with some of this cash inevitably heading to the stock market.
My analytical framework takes a foreboding view of these types of monetary inflation.
Indeed, the rapid expansion of money market assets is part of dangerous growth in financial sector leveraging – typically through the rapid expansion of perceived safe and liquid central bank and GSE obligations.
There was a push to contain money market fund risks after the 2008 dislocation exposed acute fragilities (including vulnerability to panicked runs).
After ending 2008 at $3.8 TN, money fund assets were down to about $2.5 TN in 2012 – and ended Q1 2019 at about $3.1 TN.
Assets have inflated $2.0 TN, or 65%, over the past four years.
It was leaked that the Federal Home Loan Banks increased borrowings $304 billion the week before last, an unprecedented (central bank-like) expansion to accommodate commercial bank liquidity demands (from deposit flight).
As a government-sponsored enterprise (GSE), the FHLB essentially enjoys unlimited demand for its perceived risk-free debt securities.
The CBB has a 25-year history of chronicling GSE developments.
I have a long-held view that the GSEs – with their implicit government guarantees and far-flung missions – are dangerous financial institutions that have played an instrumental role in the multi-decade Credit Bubble.
I began closely monitoring the GSEs in 1994, after recognizing they were operating as quasi-central banks.
Their aggressive securities purchases provided a critical liquidity backstop during a period of intense hedge fund deleveraging (sparked by Fed tightening after an extended period of extraordinarily depressed policy rates).
GSE (chiefly Fannie and Freddie) assets expanded an unprecedented $151 billion in 1994, to $782 billion.
The 1998 Russia/LTCM collapses induced record one-year GSE growth of $353 billion, to $1.622 TN (as of Q3 ’99).
Hamstrung by Fannie and Freddie accounting scandals, one-year GSE growth nonetheless reached a new peak of $418 billion, to $3.360 TN (as of Q2 ’08), during the instability leading up to the 2008 crisis.
GSE growth last year reached an unprecedented $921 billion, to a record $9.224 TN – with three-year growth of $2.094 TN, or 29.4%.
And it would not be surprising to see FHLB/GSE Q1 growth well in excess of $500 billion.
Over the years, I’ve tried to explain how Washington guarantees (explicit and implicit) and resulting market distortions create unlimited capacity for the GSEs to borrow and extend Credit.
Especially during crisis environments, the GSEs readily issue shorter-term debt instruments – including debt securities purchased by the money market fund complex.
Some years back, I dedicated a weekly CBB to the tedious process of walking through a series of debit and Credit accounting entries to illuminate how a GSE would issue short-term debt obligations (IOUs) to a money market fund and use this liquidity to purchase securities from an investment firm or hedge fund – where these funds would circulate through the system until being redeposited into the money market.
The GSE would then tap this liquidity to issue additional IOUs to purchase more securities – and this process could basically repeat indefinitely.
It was fractional reserve banking with the old “deposit multiplier” – a dynamic throughout history responsible for devastating Credit booms and busts.
There was, however, one momentous difference: Not subject to bank reserve requirements, GSE borrowing and lending operations were unfettered - with powerful and far-reaching “infinite multiplier” effects.
I appreciate that this pithy explanation is likely not overly satisfying.
But this “infinite multiplier” – especially in crisis environments – affords the GSEs the capacity to essentially provide a central bank-style liquidity backstop.
It is therefore reasonable to add the FHLB’s (at least) $304 billion to the Fed’s $391 billion – to calibrate the magnitude of system liquidity injections second only to Covid craziness.
For perspective, Fed Credit expanded $605 billion over three weeks to accommodate deleveraging during the acute phase of the October 2008 market crisis.
The Powell Fed today confronts a historic dilemma.
And it is uncomfortably reminiscent of how Federal Reserve officials faced in 1929 a confluence of a weakening economy, a fragile banking system, and a crazy stock market speculative Bubble.
Ben Bernanke is fond of pointing blame for the crash and subsequent banking crisis to the “Bubble poppers”.
More grounded analysis would recognize that Bubbles do inevitably burst, and the greater the inflation – the more protracted the “Terminal Phase” of excess – the more vulnerable the financial system and economy are to collapse.
Importantly, each bailout and reflation ensures only larger Bubbles – greater amounts of debt, financial system leverage, and speculative excess.
The Fed’s $1 TN 2008 QE inflated to massive $5 TN pandemic reflationary measures.
It’s distressing to contemplate how much the Federal Reserve’s balance sheet will inflate to accommodate the next serious de-risking/deleveraging crisis.
And while most will scoff today at the notion of a systemic “fire”, the reality is that the system suffered bank failures and a run on deposits, with unemployment at 3.6% and Q1 GDP growth expected at about 2.5% (Atlanta Fed GDPNow forecast).
The massive liquidity response only exacerbates perilous market instability.
While the stock market might appear exceptionally resilient, the system is acutely fragile.
There are clear risks of devastating market crashes, domino bank failures, a highly destabilizing Credit contraction, crises of confidence, and synchronized global financial, economic and geopolitical crises.
Importantly, acute Bubble fragility ensures – as we witnessed over recent weeks – that the Federal Reserve and Washington will move quickly with extraordinary liquidity and stabilization measures.
Music to the ears of risk markets that have degenerated into hopelessly dysfunctional speculative Bubbles.
Huge gains were enjoyed during the quarter by targeting large short positions and markets with outsized hedging and bearish derivatives positioning.
Short squeezes bookended a fledgling banking crisis – a major loosening of financial conditions, then an abrupt tightening and back to loosening.
What is a central bank to do?
Fed officials recognize market propensity for front-running any Fed dovish pivot musings.
Now, after a quick $700 billion shot of Washington liquidity, a downdraft in market yields, and a surge in stock prices, the Fed faces the possibility of loose conditions underpinning inflation dynamics.
For now, their strategy appears to be to create whatever liquidity the banking system might require, while relying on rate policy to sustain a semblance of an inflation fight.
Expect Fed officials to continue pushing back against market expectations of rate cuts this year.
Meanwhile, rate markets have seen more than enough to double-down on pricing in a financial accident.
Markets are in a highly unstable state.
Equities relish lower rates and another refreshingly big shot of liquidity – turning giddy at the thought of a repeat of January’s Big Squeeze.
Rate markets are in more of a quandary.
How much does “risk on” in the short-term counter an unfolding tightening of bank lending?
Does Fed and FHLB liquidity work to further reinforce inflationary pressures?
It’s worth noting that the Bloomberg Commodities Index jumped 2.4% this week.
Crude rallied 9.3% (gasoline up 4.3%).
While gold prices slipped this week, the shiny Store of Value advanced $142, or 7.8%, during March.
Silver surged 15.2%.
When I contemplate the start of what I expect to be an unruly expansion of Fed liquidity, my thoughts turn to potential dollar vulnerability.
Granted, our unsound currency has unsound competitors.
Anything could happen.
When we previously flooded the world with dollar balances, they were easily absorbed by eager buyers - including the Chinese and EM central banks.
But with all the uncertainty associated with a rapidly changing “world order,” I’m skeptical of a replay of the past cycle’s peaceful recycling of excess dollar balances right back into booming U.S. securities markets.
What a wild start to the year.
Interesting to say the least, with everything pointing to a highly unstable Q2.
March 31 – Bloomberg (Alex Tanzi): “Deposits at US banks fell sharply and lending declined by the most in nearly two years amid financial turmoil triggered by the collapse of several banks this month.
Commercial bank deposits dropped by $125.7 billion in the week ended March 22, marking the ninth-straight period of declines, according to data released Friday by the Federal Reserve.
At domestically chartered banks, deposits fell $84 billion, reflecting a decrease at the 25 largest institutions.
Deposits at small banks increased.
Overall lending fell by $20.4 billion, the most since June 2021 and due to a decline in commercial and industrial loans.”
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