Central Banks Pulling the Strings - Are We Headed for Another Crash?
Abraham George Macro Musings
In a world dominated by capitalism, it is difficult to admit that central banks control the markets. However, after nearly 50 years in the industry, I learned a cardinal rule early in my career: never ignore the central banks. More on this later, but for now, let's get to the chase.
In the last few weeks, we have witnessed a roller coaster ride in the markets due to inflation concerns and the banking crisis. Nevertheless, the markets closed above the 200-day moving average and above the larger descending trendline that describes the bear market of last year.
When I refer to "markets," I am specifically talking about the S&P 500 index as it accounts for approximately 80% of all US stock market capitalization. Although I want to believe that the Fed and the Treasury do not control the markets, we cannot ignore how much they have us all by the neck.
On Friday, news that the Treasury had called an emergency meeting with the "Financial Stability Oversight Council" initiated the bounce back in stocks. This group includes the Treasury Secretary and the Fed Chairperson along with the leaders from a host of other regulatory agencies.
However, there is another group that was formed by President Reagan following the 1987 crash. It is known as the "President's Working Group on Financial Markets." This group consisted of the Treasury Secretary, Fed Chair, the heads of SEC and CFTC, and the leaders of the major banks. As a whole, this group is better known as the "Plunge Protection Team." Although not widely used, they always exist.
The most significant action from this group happened in 2018 under President Trump when Treasury Secretary Steve Mnuchin called for an emergency meeting just the day after Christmas. Stocks and oil were collapsing, and the yield curve had inverted for the first time in ten years. That meeting created the bottom in stock markets.
What comparisons do we have now to 2018? We have everything going the same way. The Fed had raised mechanically for a ninth time and projected another two or three hikes for 2019. That meeting was also attended by two former Fed chairs, Yellen and Bernanke, to walk back expectations of more Fed tightening. By July, they were cutting rates again.
Now you may wonder why did the Fed still hike by 25 basis points last week? If you see the pattern of the Fed, the Fed prepares the market for an event and normally gives into the market expectations.
In fact, after the hike, Powell spoke about the banking stress of the past two weeks and related credit tightening, and how it has an equivalent effect to a rate hike and will weigh on inflation.
Why did the Fed still hike rates? The market had priced it in, and there was plenty of Wall Street and media commentary suggesting that a pause would signal to markets that the Fed was aware of some deeper problems in the banking system. The Fed just caved into that sentiment. Remember, this game is all about confidence and perception. Once that is gone, all hell can break loose.
The 10-year treasury yield is now around 165 basis points below the Fed funds rate. Historically, it trades about 90 basis points above the Fed funds rate. How will this get resolved? Whenever the Fed cuts rates again.
Let's go back in history for a moment.
In 1999 and 2000, the Fed got very aggressive about rates and drove the Fed funds rate to 6.5% and broke the backbone of NASDAQ. In 2005-2007, the Fed hiked rates by 425 basis points to 5.25% and broke the housing market.
Starting in 2016 through to 2018, it hiked rates by 225 basis points until the repo market went ballistic, which resulted in a crash in the stock markets. And now, the Fed has hiked farther and faster than almost ever before, and something is starting to break.
According to the Kansas City Fed report, rising rates were creating unrealized losses in the banks' bond portfolios long before. They wrote that at the year-end of 2021, only four community banks had tangible equity capital ratios below 5%. That number increased to 333 as of June 30, 2022, indicating less ability to sustain economic shocks.
Do you think the Fed did not know what was happening? They knew all along that their actions were putting a strain on the banks, but they still continued hiking rates at the same time. The Fed giveth and taketh away in its own sweet time.
In reality, if the banks had such a massive bond portfolio in the first place, it is because of government policy. During 2020 and 2021, these banks saw a massive influx of new deposits as a direct result of stimulus spending. The New York Times covered this through an article in October 2021, which said that by the end of May 2021, nearly $830 billion in stimulus check payments had been sent to individuals. Roughly $800 billion was sent to businesses in the form of programs such as paycheck protection program, and about $570 billion was spent on extended and enhanced unemployment insurance benefits.
Under normal circumstances, banks would make loans with these deposits. But the influx was so large and so fast that they couldn't keep up with the loan-making as per the bank policies. So their only choice was to move to government debt. By the second quarter of 2021, the banks already had $150 billion worth of Treasuries.
In a nutshell, fiscal policy flooded the banks with an artificially high level of deposits, forcing them into Treasuries. Now, monetary policy is destroying the value of those bonds in record time.
It is all like a video game played by the authorities. Could the banks have applied better risk measures and diligence and done things differently? Of course, they could have. But think about the role that the authorities have played in creating this mess.
If it were not for the recently announced Bank Term Funding Program (BTFP), many regional banks would have already collapsed for the same reasons as others have in the last two weeks. So the authorities will still continue to fix this, but for how long can this continue? A new day is coming when the rules of the game will change. The foundations for those changes are already taking place, and we will have much to discuss in the coming days.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office, and a hedge fund.