All you need to read for the next spin around the Sun:
(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor…
Snippen of relevant parts:
Implications of BTFP
Bigger than COVID QE
The Fed printed $4.189 trillion in response COVID. Right off the bat, the Fed implicitly printed $4.4 trillion with the implementation of BTFP. During the COVID money printing episode, Bitcoin rallied from $3k to $69k. What will it do this time?
Banks are Shitty Investments
Unlike the 2008 financial crisis, the Fed didn’t bail out banks and allow them to participate in the upside this time. The banks must pay the 1-year interest rate. 1-year rates are considerably higher than 10-year rates (also known as an inverted yield curve). The bank borrows short from depositors, and lends long to the government. When the yield curve is inverted, this trade is guaranteed to lose money. Similarly, any bank that uses the BTFP will need to pay more to the Fed than the interest rate on their deposits.
US Treasury 10-year Yield Minus US Treasury 1-year Yield
Banks will accrue negative earnings until either the yield curve is positively sloped again, or short-term rates drop below the blended rate on their loan and bond portfolios. BTFP doesn’t fix the issue that banks cannot afford to pay the high short-term rates that depositors could get in money market funds or treasuries. Deposits will still flee to those instruments, but the banks can just borrow from the Fed to plug the hole. From an accounting standpoint, the banks and their shareholders will lose money, but banks will not go bankrupt. I expect bank stocks to severely underperform the general market until their balance sheets are repaired.
House Prices Zoom!30yr Mortgage Rate Minus 1yr Treasury Yield
Purchasing MBS will still be profitable for banks because the spread vs. 1-year rates is positive. MBS rates will converge to the 1-year rate as banks arb the Fed. Imagine a bank took in $100 of deposits and bought $100 of treasuries in 2021. By 2023, the treasuries are worth $60, rendering the bank insolvent. The bank taps the BTFP, gives the Fed its treasuries and gets back $100, but it must pay the Fed 5%. The bank now buys an MBS, which is guaranteed by the government, yielding 6%. The bank pockets a 1% risk-free profit.
Mortgage rates will move in lock-step with the 1-year rate. The Fed has immense control over the short-end of the yield curve. It can essentially set mortgage rates wherever it likes, and it never has to “buy” another single MBS.
As mortgage rates decline, housing sales will pick back up. Real estate in the US, just like in most other countries, is big business. As sales pick up because financing becomes more affordable, it will help increase economic activity. If you thought property would get more affordable, think again. The Fed is back at it, pumping the price of houses once more.
USD Strong to Very Strong!
If you have access to a US bank account and the Fed just guaranteed your deposit, why would you hold money in other banking systems without such a guarantee from the central bank? Money will pour into the US from abroad, which will strengthen the dollar.
As this plays out, every other major developed country’s central bank must follow the Fed and enact a similar guarantee in order to stem the outflow of banking deposits and weaken their currency. The ECB, BOE, BOJ, RBA, BOC, SNB, etc. are probably ecstatic. The Fed just enacted a form of infinite money printing, so now they can too. The issues in the US banking system are the same ones faced by every other banking system. Everyone has the same trade, and now — led by Sir Powell — every central bank can respond with the same medicine and not be accused of causing fiat hyperinflation.
Credit Suisse effectively just failed a few nights ago. The Swiss National Bank had to extend a CHF50 billion covered loan facility to CS to stem the bleeding. Expect a near failure of a large bank in every major, developed Western country — and I suspect that in each case, the response will be a blanket deposit guarantee (similar to what the Fed has done) in order to stave off contagion.
The Path to Infinity
As stated in the BTFP document, the facility only accepts collateral on banks’ balance sheets as of 12 March 2023, and ends one year from now. But as I alluded to above, I don’t believe this program will ever be ended, and I also think the amount of eligible collateral will be loosened to any government bond present on a licensed US banks’ balance sheet. How do we get from finite to infinite support?
Once it becomes clear that there is no shame in tapping the BTFP, the fears of bank runs will evaporate. At that point, depositors will stop stuffing funds in TBTF banks like JPM and start withdrawing funds and buying money market funds (MMF) and US treasuries that mature in 2 years or less. Banks will not be able to lend money to businesses because their deposit base is chilling in the Fed’s reverse repo facility and short-term government bonds. This would be extremely recessionary for the US and every other country that enacts a similar program.
Government bond yields will fall across the board for a few reasons. Firstly, the fear of the entire US banking system having to sell their entire stock of USG debt to pay back depositors goes away. That removes an enormous amount of selling pressure in the bond market. Second, the market will start to price in deflation because the banking system cannot return to profitability (and thus create more loans) until short-term rates decline low enough that they can entice depositors back with rates that compete with the reverse repo facility and short-term treasuries.
I expect that either the Fed will recognise this outcome early and start cutting rates at its upcoming March meeting, or a nasty recession will force them to change tracks a few months from now. The 2-year treasury note’s yield has collapsed by over 100 basis points since the onset of the crisis. The market is screaming banking system-sponsored deflation, and the Fed will listen eventually.
As banks become profitable and can once again compete against the government to attract depositors back, the banks will wind up in the same situation as they did 2021. Namely, that deposits will be growing, and banks will suddenly need to start lending out more money. They will start underwriting loans to businesses and the government at low nominal yields. And once again, they will be thinking that inflation is nowhere to be seen, so they won’t be concerned about rising interest rates in the future. Does this sound familiar?
Then, March 2024 rolls around. The BTFP program is set to expire. But now, the situation is even worse than 2023. The aggregate size of the banks’ portfolio of low-interest rate underwritten loans to business and low-interest rate government bond securities is even larger than it was a year prior. If the Fed doesn’t extend the life of the program and expand the notional of eligible bonds, then the same sort of bank runs we’re seeing now are likely to happen again.
Given the Fed has no stomach for the free market in which banks fail due to poor management decisions, the Fed can never remove their deposit guarantee. Long Live BTFP.
While I’m sure that is abhorrent to all you Ayn Rand wannabes (like Ken Griffin and Bill Ackman), the continuation of BTFP solves a very serious problem for the USG. The US Treasury has a lot of bonds to sell, and less and less people want to own them. I believe that the BTFP will be expanded such that any eligible security, which are mostly treasuries and mortgages, held on a US banks’ balance sheet is eligible to be exchanged for fresh newly printed dollars at the 1-year interest rate. This gives the banks comfort that as their deposit base grows, they can always buy government debt in a risk-free fashion. The banks will never again have to worry about what happens if interest rates rise, their bonds lose value, and their depositors want back their money.
With the newly expanded BTFP, the Treasury can easily fund larger and larger USG deficits because the banks will always buy whatever is for sale. The banks don’t care what the price is because they know the Fed has their back. A price sensitive investor who cared about real returns would scoff at buying more, and more, and more, and trillions of dollars more of USG-issued debt. The Congressional Budget Office
estimates the 2023 fiscal deficit will be $1.4 trillion. The US is also fighting wars on multiple fronts: The War on Climate Change, The War Against Russia / China, and The War Against Inflation. Wars are inflationary, so expect the deficits to only go higher from here. But that is not a problem, because banks will buy all the bonds the foreigners (China & Japan, in particular) refuse to.
This allows the USG to run the same growth playbook that worked wonders for China, Japan, Taiwan, and South Korea. The government enacts policies that ensure savers earn less on their money than the nominal rate of GDP growth. The government can then re-industrialise by providing cheap credit to whatever sectors of the economy it wants to promote, and earn a profit. The “profit” helps the USG reduce its debt to GDP from 130% to something much more manageable. While everyone might cheer “Yay growth!”, in reality, the entire public is paying a stealth inflation tax at the rate of [Nominal GDP — Government Bond Yield].
Finally, this solves an optics problem. If the investing public sees the Fed as cashing the checks of the government, they might revolt and dump long-term bonds (>10-year maturity). The Fed would be forced to step in and fix the price of long-term bonds, and that action would signal the beginning of the end of the Western financial system in its current form. The BOJ had this problem and implemented a similar program, whereby the central bank loaned money to the banks to buy government bonds. Under this system, the bonds never show up on the central bank’s balance sheet; only loans appear on the balance sheet, which, in theory, must be repaid by the banks — but in practice, they’ll be rolled over in perpetuity. The market can rejoice that the central bank is not moving towards 100% ownership of the government bond market. Long Live The Free Market!
Front Month WTI Oil Futures
The decline in oil prices and commodities in general tells us that the market believes deflation is coming. Deflation is coming because there will be very little credit extended to businesses. Without credit, economic activity declines, and therefore less energy is needed.
A decline in commodity prices helps the Fed cut rates because inflation will decline. The Fed now has the cover to cut rates.