Tuesday, March 14, 2023

Morning Note: February Inflation, Banking Scare Basics, and "Mess-Making"

CPI (headline) came in inline with economists' expectations, at .4% month-on-month, 6.0% year-on-year... Core inflation (ex-food and energy) came in a titch above expectations, at .5% (vs .4% expected) m-o-m, 5.5% y-o-y.

Again (as I stated over the weekend), at this point, in contrast to what now a whole host of major WS firms are thinking pleading, we see very low odds of a bank stress-induced immediate pause in the Fed's rate-hiking campaign.

Now, make no mistake, we do believe that odds not only favor a Fed pause over the next few months, but that, given our recession thesis, they may actually find themselves cutting their benchmark rate later in the year... Just, given the, albeit lagging, latest data, not right here.

In case you're still wondering, or if you missed the past couple of videos, Lynn Alden does a nice job on the basics of the present banking crisis  scare.

Here's from her latest public letter:

"2008 vs 2023: Credit vs Duration

Back in 2008, banks in aggregate had a credit problem. They made risky loans, they had very little safe assets, and some of those risky loans started to default. Given how leveraged they were, it wouldn’t take much to render large portions of the U.S. banking system insolvent.

This chart shows banks’ holdings of cash and Treasuries (the safest assets in terms of credit risk) as a percentage of total bank assets:

As we can see, the 2008 situation was very different than what’s happening here in 2023. Today, banks have a much higher ratio of their assets in cash and Treasury/agency securities, which are nominally risk free if held to maturity. Banks also have a much higher cash-to-deposit ratio in 2023 than 2008. In addition, the rest of their asset base is in better shape in terms of credit risk too: on average banks have less subprime lending exposure, and instead they are rather concentrated into providing loans to entities with decent credit metrics.

So what’s the problem? This time the problem is liquidity and duration (interest rate) risk."


"Banks were given a ton of new deposits during 2020 and 2021 thanks to fiscal stimulus to people, and banks used those deposits to buy a lot of securities, which were low-yielding at the time. After a year of rapid interest rate increases, the prices of those fixed income securities are now lower than they were when banks bought them.

In other words, if they bought a 10-year Treasury note when yields were 1.5%, and today they are 4%, then those older Treasuries will be discounted in terms of price by about 15-20% by any potential buyers, so that they have the same effective yield to maturity (4%) as these newer Treasuries do.

Due to buying so many securities when interest rates were low that are now heavily discounted if they were to be sold, banks have a lot of unrealized losses.

Over $600 billion worth of unrealized losses, in fact:

Chart Source: FDIC

That seems quite “doomy” at first, but there’s good news. Normally, banks can hold these securities to maturity and get all of their money back. That’s why they are classified into the “hold to maturity” segment. And unlike 2008, most of this has little or no credit default risk, so if they can hold on, they’re fine.

However, if depositors pull their money out of a bank above and beyond the amount of cash that the bank has on hand, then that bank might have to sell securities at a loss, rather than hold onto securities until maturity as planned. If that happens, it can turn a liquidity problem into a solvency problem, not because the securities are defaulting like they did in 2008, but instead because the banks are selling otherwise high-quality securities at a loss (due to those securities being priced at a discount in light of recent interest rate increases) and locking in those losses. The unrealized losses become realized losses for banks that can’t keep their deposits from running away."

"...most of the top ten banks are big enough that it’s hard to pull enough deposits out to make them sell any of their securities for realized losses. It’s not impossible, but it’s hard. So far, the large regional banks and the huge money-center banks are not reporting major deposit outflows.

On the other hand, any given small or medium-sized bank with unrealized losses on their book is indeed quite vulnerable. It’s easy for deposits to move around and concentrate into the larger banks and money markets, leaving a lot of smaller banks out of liquidity and forced to sell their less liquid assets at a loss. Small banks with significant cash on hand, less unrealized losses relative to bank capital, and a large number of small depositors (rather than a small number of large depositors) are generally as safer relative to others in the peer group.

Due to the low credit risk of most bank assets, I certainly don’t see it as a “2008 repeat” like many commentators on social media have recently. Does this acutely threaten the whole financial system? No.

Is it a serious liquidity concern for many banks outside of the top ten or so? Absolutely. And that’s why the Treasury and Federal Reserve stepped in."

Asian stocks got hammered overnight, with 14 of the 16 markets we track closing lower.

Europe, however, is catching a bid so far this morning, with 16 of the 19 bourses we follow trading up as I type.

US equity averages are up to start the session: Dow by 268 points (0.85%), SP500 up 1.37%, SP500 Equal Weight up 1.66%, Nasdaq 100 up 1.38%, Nasdaq Comp up 1.60%, Russell 2000 up 2.91%.

The VIX sits at 23.59 down 11.05%.

Oil futures are down 1.89%, gold's down 0.45%, silver's down 0.46%, copper futures are down 0.28% and the ag complex (DBA) is down 0.19%.

The 10-year treasury is down (yield up) and the dollar is up 0.29%.

Among our 35 core positions (excluding options hedges, cash and short-term bond ETF), 26 -- led by AMD, Dutch Bros, MP Materials, XLC (communications stocks) and XME (metals miners) -- are in the green so far this morning... The losers are being led lower by TLT (long-term treasuries), VGIT (intermediate-term treasuries), GLD (gold), VNM (Vietnam equities) and VPL (Asia-Pac equities).

Please forgive my snarkiness, but, you know, the Fed has 400 PhD economists on staff... I too often these days harken back to the wisdom of one whose writings were very influential during my formative years:
"We have indeed at the moment little cause for pride: as a profession we have made a mess of things." --F.A. Hayek
And, if I may:
"...we’re at the mercy of a few very bright, academically gifted appointees who’ve proven to be most adept at test-taking and, alas, mess-making."
--Mazorra, Martin. Leaving Liberty? Essays on Politics and Free-Market Thinking 

Have a great day!

No comments:

Post a Comment