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Liquidity Tightens

I don’t enjoy days like today.

Not only did I lose money, but I didn’t have a clear understanding of why so much money was flowing where it was, particularly into bonds. The intra-day range in short-term bonds, the two-year maturity is shown below, moved more today than since Treasury first started issuing them in 1972, according to Bloomberg. I suspect this massive flight to quality is a warning sign.

Compared to bond markets, equity markets, which is what most people care about, have been calmer. The stock market fell less than 1% today and is up on the year. But I am more concerned about all markets now than I was a week ago because if things were functioning normally you would not be seeing such enormous price swings. Things are moving fast. I am updating you because if I was in your shoes I’d want an update, even though I have more questions than answers.

My hunch is that:

a) The US authorities guaranteed the deposits of SVB, even if they were above Federal Deposit Insurance Corporation limits, but did NOT guarantee the deposits of all US banks with deposits above FDIC limits.1 The data I don’t have is if people are pulling their deposits from regional banks (whose names I have barely heard of) and putting this money into Treasury bills or one of the big 4 banks. The data on these deposits will come out later in the month.

Distinguish between people who hold equity in a bank and people who hold a deposit in a bank. They are different. If enough people pull their money, more banks could collapse such that equity holders get hurt, even if the deposit guarantee is eventually extended to all people such that depositors actually face no risk.

(That’s a possible scenario, not a prediction. This is NOT investment or financial advice. I am sharing with you what I am thinking).

The prices on the screen suggest there may be a stampede out of such deposits. Bond yields plummeted as if the Fed was going to begin cutting rates even though the Federal Reserve is likely to raise interest rates next week. If the Fed does hike, when such a hike is not “discounted” by the market, expect more pain, meaning declines in stock prices. Nothing has changed about the inflation readings, they are still high (like around 5%) even if inflation “lags” and will come down eventually, probably later this year.

b) The Switzerland-based bank, Credit Suisse, is trading as if it won’t exist soon. The bank was felled, like SVB, by greed, in this case lending aggressively a few years back to hedge fund clients that made bad trades and then goofing up its accounting. I have two questions. First, how protected are banks in the rest of the world, in terms of credit exposures to Credit Suisse? Second, if Switzerland takes over Credit Suisse, how do they pay for it? The liabilities of Credit Suisse, $679 billion, are only slightly smaller than the GDP of Switzerland, $800 billion.2

Other Questions

How much total money is in second-tier US bank deposits? What percent of the holders of this money are paying attention to what is going on? If I calculate how big the moves are in bond markets, do they add up, i.e. are these the depositors the people buying bonds?

Also, were today’s moves exacerbated by an institution or institutions that had large speculative positions (like short bonds) that were forced to cover those positions given the market movements?

Finally, what is Powell going to do? Inflation got out of control on his watch and now he has raised rates quickly without carefully monitoring bank balance sheets for collateral damage. If he flinches and doesn’t hike, his inflation credibility is shot. On the other hand, this banking crisis will crush lending, so the banking crisis in a way is doing the Fed’s job. I think the right thing to do is a) provide liquidity to the banks and b) raise interest rates until there is solid evidence inflation is coming toward target.

The Root Cause

The root cause of this turmoil is the price on one of the most widely held instruments—government bonds—changed. (The root cause of that is higher inflation, which goes back to pandemic stimulus and supply problems). Specifically, the yield on US government 10-year bonds rose to around 4% from less than 1%.

How can this wreak such havoc?

Traders quote bonds in yields and stocks in prices. This is confusing. Better to look at it all in price terms or in yield terms. In price terms, the 10-year bond lost around 25% of its value. The same thing happened in Europe and much of the rest of the world. Losing 25% is painful but there is a HUGE difference if you are levered and experience these losses or not.

If you lose 25% when you are levered, what happens next depends on how much capital you have available to cover losses. Levered players are getting whacked on these bond price adjustments. In simple terms:

—SVB bank was, like all banks, levered roughly 10 x 1. So a 25% loss is a big deal, given that they did not hedge this risk.

—UK pension plans that bought longer duration bonds that suffered a major rout last year were in the same situation.

—Is there someone else? If so, who?

Of course, the massive rally in bonds in the last three days makes these problems less intense (because losses on the bonds decline) BUT, it also doesn’t make much sense, to me unless, again, we are on the verge of a broader collapse in liquidity.

What am I doing?

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