#63 - March 2023: Something broke, QT is over - the wind just changed

My honest thoughts on the state of the market, for Paid Subscribers

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Hi all,

Do you feel it?  The wind just changed. 

For ~15 months, we’ve been waiting for the Fed’s unsustainable rate hikes to break something in the financial system and disabuse the Fed of their delusional fantasy that they could actually implement quantitative tightening (QT) without causing calamity.  Well, something finally broke. 

Ironically, it’s the same thing that broke in 2008, just for different reasons – banks’ balance sheets.  In 2008, it was heavy exposure to risky mortgage-backed securities.  In 2023, it is heavy exposure to long-dated US Treasury bills – supposedly the least risky asset on the planet.  We will dig into exactly what happened, but first, I want to draw your attention to the smoking gun – the chart that definitively says the winds have changed.

This graph is the Fed rate futures market.  This is where the smartest bond traders and Fed watchers bet on what the Fed’s interest rate will be in the future – in this graph, the bars on the far right are ~1 year from now.  These snapshots show what this market was pricing in, day by day, as the last week played out. 

On March 8th, the market was expecting the Fed to hike rates by an additional +1% by end-of-year 2023.  By March 15th, the market’s expectation had flipped – now expecting the Fed to cut rates by -1% by end-of-year 2023.  The banking crisis is the pin that burst the Fed’s hawkish bubble, and the market knows it. 

What this means is that after ~15 months, quantitative tightening is dead.  And now, we’ve just begun the 5th era of quantitative easing (QE5).

If you have any doubts that it has begun, just see what happened to the Fed’s balance sheet this week alone – a whopping +$300B in assets have already been created out of thin air, offsetting roughly half of all of the balance sheet reductions the Fed managed over the last year.

Here’s a zoomed-in view of just 2022-23 for this same data:

Furthermore, there’s no shortage of additional color about the magnitude of what the Fed now faces in terms of crisis.  These charts show, respectively, that discount window borrowing by banks from the Fed has spiked higher than even 2008 & that “systemically important” mega bank Credit Suisse has a much higher likelihood of failing than in 2008.

But how did we get here?  What happened?  You’ve probably gotten the general idea by now, but let’s lay out a simple summary:

Silvergate Bank

• Silvergate was the first bank to succumb to the pressures of the current banking climate.  Silvergate was the biggest banking name in the crypto industry.  They were well acquainted with the harsh volatility of crypto markets (and the resultant ebbs and flows of deposits), and were well capitalized to weather a bear market as a result. 

• However, they made the mistake of banking FTX and Sam Bankman-Fried.  With the ~$10B FTX fraud collapsing, Silvergate had an unexpected hole in its deposit base.  Worse, regulatory scrutiny descended on Silvergate, making many customers uneasy about the possibility that Silvergate could be in trouble. 

• An exodus of deposits commenced, eventually exceeding what Silvergate had accounted for in its risk models.  And, as with all fractional reserve banks (meaning, all banks), they depleted the assets they had on hand to satisfy withdrawals and had to enter voluntary liquidation.  A classic bank run, exacerbated by FTX’s fraud.

Silicon Valley Bank

• SVB got themselves into trouble by a simple mistake in the heady days of the pandemic response bull market.  At EOY 2019, SVB had $62B in deposits.  At EOY 2021, SVB had $189B in deposits.  This massive increase in deposits at the bank had to be put to work – that’s the entire banking business model, after all.

• However, SVB couldn’t possibly find worthy borrowers for $127B in capital.  As a result, they invested $80B of it in 10-year-duration mortgage-backed securities at 1.56% yields.

• This decision makes sense if you don’t expect the Fed to raise interest rates to 5% in the next year, as has happened.  The Fed’s aggressive tightening cycle has had a two-part effect.  First, those mortgage-backed securities drop significantly in value.  Second, the entire tech sector contracts dramatically, causing lean times and layoffs for companies, and huge influx of net withdrawals from the banks that serve them. 

• The combination of these two factors pushed SVB into dangerous territory.  To meet the spike in withdrawals, they were forced to sell 25% of their underwater mortgage-backed securities, realizing a $1.8B loss on the sale, which was announced on March 8th. 

• Just like with Silvergate, this news betrayed the weakness of SVB and accelerated the run on the bank.  Customers and investors ran for the exit.  The bank’s stock dropped 62% on March 9th, and an additional 66% on March 10th.  The same day, the bank was shut down and handed over to the FDIC to handle. 

• To put this development into context, SVB is the largest bank failure since 2008, and the second-largest in U.S. history. 

Signature Bank

• This one is a little different, and a little shocking.  Signature Bank may or may not have been in mortal peril as a result of the same systemic pressures facing all banks.  With everyone now concerned about the trustworthiness of their bank, withdrawals spiked – especially true in the crypto and tech sectors, as companies became concerned that Silvergate or Silicon Valley Bank could play out again.  This meant that Signature Bank was dealing with major outflows, but we don’t actually know if it would have eventually been too much for them – instead, the government stepped in first.

• The move appears to be motivated at least in part by regulators’ desire to send a message to banks that crypto-friendly banks are not in the good graces of US regulators. 

• Former U.S. Congressman Barney Frank described the action as being a “very strong anti-crypto message” before later walking the statement back. 

• U.S. Congressman Tom Emmer sent a formal letter of concern to the FDIC demanding answers to the matter.

• Subsequent reports surfaced that suggested Signature Bank’s CEO may have committed fraud, and that this was the justification for the FDIC to step in and seize Signature Bank.  Perhaps this was exclusively the reason, perhaps it was a mix of reasons, or perhaps alleged fraud was merely the excuse to clamp down on crypto-focused mid-size banks.

First Republic Bank

• First Republic is a California regional bank also known for banking tech startups.  As a result of Silvergate and SVB experiencing bank runs, First Republic became an immediate victim of contagion.  Customers recognized that First Republic shared many of the same geographic and customer base characteristics of Silvergate and SVB, and rushed to withdraw deposits just to be safe – making a bank run a self-fulfilling prophecy.

• First Republic’s share price fell 85% in the first two weeks of March.

  

• On March 16, a group of big banks announced that they would collectively inject $30B of deposits into First Republic Bank – a show of mutual self-interest, as stemming swirling fears and bank run contagion became an existential matter for the entire fractional reserve banking industry.  This sufficiently stabilized First Republic such that it is no longer in immediate danger of insolvency. 

Credit Suisse

• For months, Credit Suisse has been dealing with massive deposit outflows.

  

• There was no way to know exactly when these outflows would become too great for the bank’s balance sheet to handle, but the market increasingly became concerned that Credit Suisse would fail.

  

• On March 15, that magic threshold seemed to have been crossed, as the market suddenly began to price in a much greater likelihood that Credit Suisse would fail within a year (as seen via the price of Credit Default Swap contracts that pay off in the event of failure of the entity).

  

• As of today, UBS has offered to buy Credit Suisse for the fire-sale price of $1B, equivalent to 25 cents per share.  For those looking for parallels to 2008, this effort by the banking industry to absorb distressed big banks into even bigger banks is reminiscent of the Bear Stearns saga that took place in the early months of the 2008 crisis.  Only time will tell if this crisis continues to snowball as in 2008.

That’s the breakdown of current events in the banking crisis up to today, and my belief that this week was the one we have been waiting for – the inevitable moment when the Fed’s rate hikes broke something in the financial system in a big enough way to force the Fed to end its doomed ~15 month effort of quantitative tightening and force the Fed back to switch back to quantitative easing in the near future.

Now, we can take a look at:

• Exactly how QT broke the banks

• What the Fed’s emergency response is & what it means

• What this all means for Bitcoin

This analysis has previously been reserved for investors in my fund, but now I’m making it available to Paid subscribers on Substack as well.

Consider upgrading to a Paid subscription OR try a 7-day free trial to give it a look.

How QT broke the banks

To understand what the Fed’s current solution is to this banking crisis, we have to first understand why banks are in trouble.  The case of Silicon Valley Bank is the most instructive here.  In the heady days of 2021, SVB was flush with new deposits and stashed a large chunk of that money in 10-year US Treasury bonds earning 1.56% interest annually.  That’s all well and good, except the value of those bonds goes down dramatically if interest rates rise.  And that’s exactly what happened in 2022, as the Fed hiked rates to ~5% in a blistering (and foolhardy) attempt to bring down inflation and pull off a miraculous “soft landing”. 

The only reason you would buy bonds yielding 1.56% when you can go buy freshly-issued bonds yielding 5% is if the 1.56% bonds are priced at a hefty discount – in fact, for garden-variety bonds of this sort with a 10-year duration, the “fair value” of the 1.56% bond is 73.4% of its original “face value”.  In other words, $1B in low-interest bonds is now only worth $734M.  That’s a steep loss to take, so as a bank you’re hoping you won’t need to sell those 10-year bonds – at least, not until the Fed’s interest rate comes back down (and the discount to face value shrinks).

But, the problem with the Fed hiking interest rates as high as they have, as fast as they have, is that it causes economic contraction at the same time.  For tech startups, funding dries up – you need to use the war chest you have in the bank, and so you start to draw down your deposits there.  The entire economy goes risk-off.  Wallets tighten, businesses see tighter cash flows (but their expenses don’t necessarily decrease).  The result is everyone draws on their savings – withdrawals flow from the banks.

And just like that, you have a problem.  By hiking interest rates, the Fed simultaneously put a large portion of banks’ balance sheets in heavy unrealized losses (all the money tied up in long-dated bonds purchased at low yields before 2022) AND created heavy net outflows from banks’ deposits.  With enough withdrawals, banks are forced to free up the money stored in the underwater long-dated bonds.  This means realizing those 26.6% losses, which are subtracted from the bank’s equity (meaning, the value of the bank). 

The Fed created the tinderbox by which banks investing in the world’s “safest” assets (US Treasury bonds) in 2021… are now causing them to go insolvent in 2023.

The Fed’s emergency response – BTFP (Bank Term Funding Program)

On March 13, the Fed announced its solution to this banking crisis – the Bank Term Funding Program.  This is an amazing measure in its earnest, simple intentions and enormous unintended scope and scale of its knock-on effects.

In simple terms, the BTFP is the Fed pledging to pay banks face value for their underwater bonds, if they need to sell them.  That way, if a bank finds itself in SVB’s position (having to sell underwater long-dated bonds at steep losses in order to free up cash to meet a spike in withdrawals), they will not have to take heavy losses that could put them out of business.  Brilliant, mission accomplished.

Of course, how the Fed does this is by printing money out of thin air.  This is why the Fed’s balance sheet jumped $300B in the last week – some banks have already taken them up on this new program, to the tune of half the balance sheet reductions achieved over ~15 months of QT.  And obviously, this means that newly created money is being injected into the system, which means that QE conditions are back.

One of the odd knock-on effects of the BTFP is that the Fed could actually continue raising rates without causing further harm to the banking sector.  All it would mean is that the Fed would just have to write bigger checks to banks as their underwater bonds went even further underwater.  So, in a way, the Fed could still try to raise rates and stay tough on inflation (while appearing in control), when in reality they have switched back to money printing and QE is the law of the land.  We shall see if they try to play that card at the next Fed meeting – if they do, it will only be for optics, and the market is already pricing in interest rates 100 bps (1%) lower by EOY 2023.

Another troubling consideration with the BTFP is that this blank-check backstop creates no incentive for banks to do what they can to get themselves out of trouble.  On the contrary, it creates an incentive for banks to game this new system – to rely on the BTFP.  As a result, when the current one-year coverage of the BTFP program is up, it’s likely that plenty of banks will not be ready for that backstop to disappear.  (Or more accurately, plenty of banks will rightly anticipate that the government will extend the duration of the program and will not even attempt to get ready for the program’s end.)  Because of this, the government will take the path of least resistance (and least political risk) and simply extend the program… with no clear end date in sight.

Finally, the BTFP creates an uneven playing field in the bond market that will surely be exploited.  Certain financial institutions are eligible for the BTFP while others are not, which means underwater bonds are worth more to eligible financial institutions (since the government has promised to pay face value for them). 

By cracking this door open, the Fed has created a blank check to backstop the banking sector by paying face value for any underwater U.S. Treasury bills.  But hey, it’s not a bailout – that’s a dirty word. 

What this all means for Bitcoin

As the banking crisis has unfolded, Bitcoin’s price has seen sharp gains.  The value proposition of Bitcoin (non-sovereign, immutable digital bank account) suddenly makes a lot of sense to many who previously did not see the point.

This has even led a prominent tech investor to bet $1m that Bitcoin will reach $1m/coin in the next 90 days.  This is, of course, not actually going to happen on such a short timeframe (though I do personally believe that it will happen within 10 years). 

What it does mean for Bitcoin, however, is still substantial.  QE is back.  This also means that high inflation is here to stay.  And in those conditions, Bitcoin will outperform – just as it did in the wake of the Covid stimulus.  (And just as gold (the other hard money asset) did in the stagflation of the 1970s). 

It’s not a stretch to say that this marks a major milestone in the ongoing demise of the dollar-based monetary system – a further erosion of the financial standing of the U.S., the dollar, and U.S. Treasuries as the preferred reserve asset for the world. 

In terms of what this could do for Bitcoin’s price, I caution against jumping to the conclusion that Bitcoin will have a major bull market here.  I continue to believe that Bitcoin’s major bull markets are driven primarily by the supply/demand effects of the halving (reminder: the next halving will happen in 13 months). 

However, these events could create the catalyst to carry Bitcoin’s price considerably higher from here, as it is still coming out of the excessive pessimism of its bear-market lows.  As a reminder, here is the chart I included in the December 2022 update to characterize my view of where Bitcoin’s price was in the four-year cycle:

Personally, I expect that Bitcoin will see an additional 30-50% of upside before the next halving, which would be in-line with that rally out of the price-bottom gray zone shown above.  And of course, I’d be pleasantly surprised if QE switching back on creates a bigger effect than that.  No matter the effect of current events this year, I think 2024 will be an even bigger year because of the impact of the halving.

Thanks,

Jesse