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Liquidity drought - Is the Fed learning from its mistakes? A brief analysis of a possible crisis
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Liquidity drought - Is the Fed learning from its mistakes? A brief analysis of a possible crisis

created Natalia Bojko15 March 2023

The last few days in the markets have brought a whole lot of speculation about a repeat of 2008. Such crises were not to happen again. History shows, however, that not always the mistakes we make in the past are a lesson not to make them in the future. It may seem to many that the “2008” scenario is inevitable at this point. In today's post, I would like to tell you a little more about the very structure of the current bankruptcy of banks and the reasons for what is currently happening before our eyes. At the outset, I would also like to leave you with a thesis in which the actions of the FED (those of the last 4-5 years) are the main fuel for today's catastrophes of the banking sector.

Let's go back to 2018

Thinking back to that period, more precisely to the time closer to Christmas, the first speculations began to appear on the market regarding the end of the asset purchase program by FED. Ultimately, the balance sheet of the Reserve was to be slightly depleted. Anyway, the year 2020 has come, which again brought the Powell team to the tracks of relaxation. Many speculated at the time that the Fed would "never" go ahead with full cuts and that stimulus measures would be thrown into the market indefinitely. Meanwhile, bankers treated the Covid stimulus amidst low interest rates as something of a "trial of strength" before stagflation becomes obvious to the public and the Fed starts tapering.

Modern Monetary Theory – how to explain and rationalize

I do not know how many of you know this concept, but when talking about FED policy, it is impossible not to mention it. In our modern times, the concept of modern monetary theory has spread through the financial media. According to it, the dollar is the most important reserve currency in the world (although its share in global reserves is declining), the central bank can print money indefinitely without inflationary consequences. This concept became the basis Modern Monetary Theory. Perhaps after reading this you feel some nonsense - if so, correct. Money creation by the central bank ALWAYS it has its consequences. The laws of supply and demand, including the inflationary processes fattened on printing, will reverberate in the market sooner or later.

I want to remind you here that Great Depression was preceded by years of market stimulation by the central bank. He then raised interest rates to critical levels. It was only years later that the head of the FED, who "fought" with the effects and problems of the crisis years in the USA, admitted his mistake. Let's quote Ben Bernanke here.

“Because of institutional changes and erroneous doctrines, the Great Contract banking panics were far more severe and widespread than would normally be the case during an economic downturn.”

Who benefited from the crisis?

Of course, until now, many theories have been developed about who benefited most from the 2008 crisis. Based on the facts, I think it's worth talking about the absorption of small banking institutions by the giants. Maybe not many people are aware of it, but companies like JP Morgan and Chase National were suddenly in the perfect position to take over unlimited banking power in the US. If we were to look back over the last hundred years, banking in the United States was highly decentralized. There were thousands of “local” banks all over the country that were not affiliated with what I will call the “mother bank” giant. I am writing about all this here because the result of this crisis is the absorption of 9000 small banks by international giants. Therefore, there is only one conclusion - thanks to the activities of the years 2007-2009, there was a complete centralization of banking services. Do you already notice some analogies to the current situation?

If we add to this government programs that support specific sectors or social benefits, then in addition to low rates and huge stimulus from bankers, money (which was perfectly visible during covid and unemployment benefits) is literally dropped over the US from a helicopter. Hence the pocovid demand has literally exploded, resulting in inflation.

The curve will tell us the truth

The US Central Bank is the largest investor in the government-issued bond market. If the Fed begins to pursue a policy of raising interest rates to "critical" levels, asset purchases automatically tighten. As a result, the curve begins to flatten out. This means that short-term government bonds will end up with the same yield as long-term bonds, and investment in long-term bonds will decline. The flood of long-term bonds causes the value of the currency to fall and the dollar to flood back into the US. The result, of course, is inflation.

USA bonds

The current level of the yield curve perfectly illustrates the possible lack of liquidity, which I will talk about in a moment when commenting on the current situation with bank failures in the United States.

Over the past few days, there has been an avalanche of information and numerous theories surrounding the fate of a bank in California known as SVB (Silicon Valley Bank). SVB was the 16th largest bank in the US until its sudden collapse and insolvency on March 10. Officially, the reason for this is the loss of liquidity due to the sale of bonds. The result of this market operation was the inability to pay out deposits – i.e. bank liabilities collected from customers. There are already a whole lot of articles describing the bankruptcy scheme step by step. How I would like to focus in this article on a slightly broader context - a possible "liquidity drought", of which the collapse of SVB was the first, more serious symptom. The lack of possible liquidity is perfectly shown by the inverted curve, the movement of which below zero proves this anomaly (yields of 10Y bonds fell significantly due to the increase in the price of bonds).

You don't need much

At this point, given the inflation target, high interest rates at the Fed, which some bankers consider "unrestrictive"  you don't really need many moves on QT (reciprocal of easing and QE) to move the credit markets. As a curiosity, it is enough to look at how the lack of quantitative easing, i.e. buying assets from the market under QE, has worked in the past.

federal balance sheet total

Source: qnews.pl

The periods of the largest increases on the indices are the moments of reprint avalanches, where the largest one had its origin in 2020. The mere lack of QE between 2015 and 2020, also taking into account the risk aversion resulting from the pandemic, contributed to a longer stagnation on the charts .

Liquidity crisis

It seems that the first signs of a liquidity crisis are surfacing with insolvency of the SVB and closing Signature Bank. In the meantime, there was also a suspension of quotations on the shares of the FRC bank. It's all about liquidity. With higher interest rates, banks have a hard time borrowing from the Fed. This brings a second leg in the form of corporate loans from banks. This means that companies that had financial problems and exposure to unprofitable investments, using an easy loan to "maintain" them, no longer have such an opportunity. They will not be able to artificially (with the use of a loan) maintain operations that are not profitable (causing a loss), they will have to resign from buying back their own shares, which imitate that their shares seem valuable. Perhaps (we are already observing it to some extent) mass layoffs will begin, which will ultimately protect the financial result. I think that SVB has uncovered a destructive cycle that we will also observe in other banks with a similar business profile. I mean one that finances even venture capital. Also, a single case of SVB may not be the second Lehman Brothers, but simply one of many who will start a liquidity avalanche. With all the news about the SVB, it's easy to forget that it all boils down to one big issue - the Fed's stimulus measures. They created an economy completely dependent on easy and, above all, cheaper (due to low interest rates) liquidity. Now that easy money has been taken away from her.

For now, a "temporary" solution is the introduction of deposit guarantees by Yellen and Powell. This solution is similar to trying to seal a huge hole in the ship with duct tape. It can also be said that the current situation is a moment between the hammer and the hard place. On the one hand, a tool that would be able to stop liquidity processes is further stimulation. On the other hand, it will again come full circle of the stagflation machine. The market's false hopes for a return to QE and near-zero rates may not help drive the markets northward.

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About the Author
Natalia Bojko
Graduate of the Faculty of Economics and Finance, University of Białystok. He has been actively trading on the currency and stock markets since 2016. It assumes that the simplest analyzes bring the best results. Supporter of swing trading. When selecting companies for the portfolio, he is guided by the idea of ​​investing in value. Since 2019, he has held the title of financial analyst. Currently, he is the co-CEO & Founder in the Czech proptrading company SpiceProp. Co-creator of the Podlasie Stock Exchange Academy project (XNUMXrd and XNUMXth edition).