Odd Lots - Here Are the Signs of a Slow-Moving Credit Crunch

Episode Date: April 24, 2023

The big headlines from March's banking crisis have receded and balances at some of the Federal Reserve's emergency lending facilities, like the discount window, are starting to fall. But if you look closely, there are still signs of strain in the depths of the financial system. And of course, there are still plenty of worries about whether deposit outflows from banks will lead to a broader credit crunch that could tip the US economy into recession. On this episode of the Odd Lots podcast, we speak to Ben Emons, senior portfolio manager at NewEdge Wealth and a longtime portfolio manager at Pimco, about what the banking drama means for everything from US mortgage rates to the vast "repo" market that's often described as the plumbing of the financial system.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor.

Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Wisenth. So, Joe, we are recording this on April 19th, and we are firmly in the middle of bank earnings season. And so far, it seems pretty good. You always know it's going to be a good one when we have to state the date of front. That's a sign. It's like, okay, we're right in the thick of it.

That stuff is happening. We're talking about news. It's going. on right now. This is not some big theoretical thing where we're going to be talking about some ancient economic theory from 100 years ago. This is right now. That's right. So, you know, obviously we had the banking crisis in March. And we have seen some signs of distress in the financial system start to fade since then. So things like borrowing from the discount window that has gone down from the peak that we saw at the end of last month. And then, of course,

if you'd been listening to odd lots before then, you would have known that discount lending was ticking up for months even before March. But the point is that if you look behind some of these headlines, headlines about bank earnings, headlines about, you know, discount borrowing, starting to come down, some signs of strain beginning to evaporate. If you actually look into the guts of the financial system, there are still some issues and some maybe suggestions. that there are more problems to come. Right. I think that's a really good summary.

Early March with the Silicon Valley Bank implosion and some other concerns, like that was like fears of financial crisis. And it faded pretty quickly, like those acute fears. But then there are the other questions. It's like, okay, well, it's like, all right, the banking system maybe is still chugging along. But what does it mean for credit? And how much of a mark will it leave on the sort of broader economy in general? that we had this moment and that all these sort of banks saw what can happen if they get on the wrong

side of certain trends. Totally. And, you know, banks are obviously big players in a lot of different markets, but a big one would have to be bonds, all sorts of different types of bonds. So everything from treasuries to T bills, to commercial mortgage-backed securities, to residential mortgage-backed securities. And so the question is, if there's more regulatory scrutiny on all of these things, if there's more concern about interest rate risk and duration exposure, is the appetite, the bank appetite for those assets still going to be there? And even though we've seen some of the crisis headlines fade away, we know that use of

the Fed's reverse repo facility, for instance, the RRP is still pretty high, which means, you know, a lot of money is still moving out of banks into money market funds and they're parking that at the Fed. So the major disaster headlines may be gone, but there is still this evidence of strains in the background worries about a credit crunch, a possible collateral crunch. Of course, those two things are interrelated. So we need to talk about all this. We need to get deep into the guts of the financial system and talk about what's going on. And I'm very pleased to say we have the perfect guest. We are going to be speaking with Ben Emmons. He is a portfolio manager over at New Edge wealth. And before that, for a long time, he was a portfolio manager at Pimco. I believe it sat fairly close to Bill

gross at the time, which must have been an interesting experience, to put it mildly, but someone who can talk to us about, you know, what is going on in this market, what do banks actually mean for bonds? Are we seeing signs of an unfolding credit crunch and collateral issues? So, Ben, thank you so much for coming on all thoughts. Hi, Tracey. Hi, Joe. It's great to be here. Thank you. And I'm glad we can finally get you on. One thing I was wondering, just as I was sort of doing some of the prep for this episode, how do we actually measure credit? in the banking system. And what do we look at for signs of strains? I'm aware, for instance, that

suddenly everyone has woken up to the Fed's H8 data, which hasn't gotten a lot of attention for a long time. But what are we looking at here? Yeah, the H8 data, the arcane data, if you think about it, right? It's like, you know, you wouldn't really pay attention to it unless you were in the 1980s a trader then and standing at the Xerox fax machine eagerly seeing the money supply numbers coming off And then making an assessment, okay, the Fed is doing this or the Fed is doing that. And that's a little bit what we're dealing with today too, though. And you would say that that data now is important because this term called bank credit that's in there. There's 17 trillion or unchange currently.

That accounts for all the loans and securities that the banks have on their books. And that's ultimately how they extend credit or contracted. So if you look at that number and the change in that, which happened over the last some, month or so. It was kind of a few hundred billion that changed it. Now that's what people look at. There's a credit change. Right. So every Friday, the Fed releases this table called the H8 data, assets and liabilities of commercial banks in the United States. And it's interesting to get this historical perspective because back in the day, 40 years ago, whatever, the Fed didn't give much in the way of communication about its policy. It just had some sort of money supply target. And so people

would look at this data to see how it was doing. Now, though, it's, you know, we get all this communication, but it gives us some additional information about the growth and contraction of credit. Yeah, indeed. And I think even so that you could think of that as you listen to Fed speakers and they point to this data, they seem to be quite confident that there isn't really anything, you know, materially going on. Sure.

But everybody paying attention to it means like, you know, I'm going to try to distract the signal from this because, you know, if it does show more material decline in bank credit in this case, then the fat would react to this, right? And that's what happened in March. Just in terms of measuring credit, so this is volume, but then there are, how do you incorporate the surveys of businesses we're having a harder time getting a loan? That seems to be getting worse. Or the loan officer's survey where they have been reporting. Tighter. Tightening, yeah. Or spreads. Obviously, we can look at, you know, junk spreads or CMBS spreads, etc. So, like, is it one of those things where, like, all of the, we're all blind and, like, touching the side of

the elephant and just trying to gather as much different pieces of it as possible. Yeah, the idea of a dashboard, right? And you have all these different signals that come at you. Obviously, what you're summarizing are different parts of the credit markets, because if you were to look at spreads and you look at, say, junk bonds, you know, that's little to do with the bank credit itself, unless there's underwriting from an investment bank in there. Even so, it's not really what we're looking at here today, commercial bank credit,

which is really about mortgages, about consumer loans, about credit cards, about credit cards and things like that. But you're right. You have to look at a broader spectrum of measures about what credit is really doing in the economy because it gets extended in different ways. So I think if we take the H8 data and also the H4 data, I was going to mention that too, which is the fast balance sheet data every week, just the aggregate. The change in that does give a sense where we are right now. Like we've risen rates a lot. It starts to affect the economy. People know that eventually banks will pull back and the earnings from banks show. to they start the provision for loan losses as a sort of a precautionary measure. But I think

what happened in March was a reaction to what ultimately happened where banks can extend credit through, and that's deposits, right? And deposits have obviously declined. Well, this is exactly what I wanted to ask you. So let's step back for a second and talk about why a credit contraction could materialize. So what are the dynamics that are affecting banks at the moment? You know, I mentioned that if there's additional regulatory scrutiny on interest rate risk, then obviously that could affect appetite for certain types of bonds. But you also have a situation where banks may be nervous about the future. They may be increasing or hoarding their reserves. And that would also start to curtail on their lending. So walk us through how this materializes.

Yeah, I was looking at the other day, Tracy, of thinking of different channels that currently showing some signs of that credit crunch stress. So one is then that leverage loans, which is, you know, or syndicated loans, that has to decline quite a bit. And that has to do with that during the pandemic boom, a fair bit of financing took place because of all the hype that bank sitting on a lot of like residual loans on that balance sheet. And having a hard time getting rid of those loans, you know, they have to be discounted and low value.

And therefore they pull back from that syndicated loan market and pushed it into the private credit market, which, although have been lending, are lending at higher rates, right? So it affects credit that way. Secondly, it's the commercial paper market, which is interesting that was mentioned in the Fed Minutes too. That's frozen, so to speak, meaning there's very little issuance going on. I always get bad flashbacks to like 2008, 2009 when we start talking about commercial paper and that's seizing up. Yeah, and that was happening in 2020 as well, right? And that's in March of 2020, the market completely collapsed. And the Fed actually did something about it.

This time, it seems to be driven by, yeah, little appetite to issue these commercial paper at this moment as one on the channel. Can you talk about, you know, different slices of the credit market? I think one of our longtime guests who we haven't had on a while ago, Chris White, you know, talked about these different slices of the credit market. Essentially, each being their own world, each being their own ecosystem. So when you talk about, okay, banks no longer being able to sell into the leverage loan market and having to move into the private credit market, I don't know what, like, what is the difference between these markets? Why do they have a different complexion? Why is the cost of funding in the latter higher?

Well, two things there. So one, the private credit lenders, that's called special lending. Okay. Or direct lending. I mean, you know, they use different terms. They don't act like a bank. You have to think of like companies like Apollo or companies. KKR or Blackstone. You know, they lend to mid-size, to smaller-sized companies that cannot go to a bank or find it harder to go to a bank, as in the lending standards are tighter at a bank than they are at a private lender. Yet the interest rate that they pay, which is typically a spread over the standard overnight

funding rate, if I'm secured overnight funding rate, sorry, you know, it's wider, right? Private lender will ask for more compensation on taking risk of a company that generate, say, 50 million EBITDA, if you call that way, per year. So on the other end, you have the syndicated loan market, which now is a bigger market, like there's a bigger companies involved. I really think there was what the leverage buyout boom that happened briefly in 2020, contributed to the banks pulling back, and now provisioning for it too. That's what showed up in the earnings data so far.

And that's actually the point that what you were asking about three issues, is that, you know, where I really think where the crunch comes from is that if we're getting banks starting to accumulate more and more reserves, lend out less or less incentivized to lend, and then you're getting a really pressure on other markets, other credit markets, that have to then no longer having the access to banks, because they ultimately provide the liquidity and the credit for the system, right? So I think this is where the real issue is. And people, if you really think of back of history, as you often do on the show, you think

of Friedman and Schwartz studies about money supply. What they really looked at was like what banks in the 30s did too, they started to really accumulate reserves quite significantly and it led to this huge contraction of credit in the economy. Now, we're not there here today yet because it's not like that at that time, but we have had instances of this. You know, 2018, 19 was an example where it turned out as the Fed kept reducing its balance sheet, the banks in the meantime were worried about the economy and start pulling back and start accumulating reserves. Not every bank has access to the Fed reserves, by the way. So there is another aspect of that too.

So I think if you summarize it, the different aspects of the credit markets, the private lending is really different from bank lending, clearly driven by different, I think, covenants and underwriting standards and lending standards. But then the banks themselves are, I think, in a very precautionary mode currently, and therefore there is that possible risk of this, you know, further pressure on lending in the economy. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute.

Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board, of over 80 bond funds, actively managed by a 200-person global squad of sector specialists,

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in Sauton Canada. So one of the interesting things that we've seen, and again, this is sort of

in the background, and I haven't seen it discussed that much, but I think risk premiums on things that tend to be dominated by bank buyers. So, you know, mostly securitized products like residential mortgage-backed securities or commercial mortgage-backed securities, RMBS and CMBS, which I mentioned in the intro, risk premiums on those are higher than a lot of unsecured stuff. And I would guess the assumption is because people are

thinking that banks may be less incentivized in the future to buy those types of assets. given what we just saw and the additional regulatory scrutiny or caution that we're expecting now. Talk to us about those markets and what sort of impact you see there. Yeah, we really think about the agency mortgage-backed securities market in particular. That's an asset class that, you know, there's still government guarantee, by the way. Right. Right. So you're not worried about credit risk, just the rate risk. Just purely the rate risk.

And, you know, a simple math of mortgages is that if rates go up, the repayment speed of mortgages goes down and it actually extends the maturity of a mortgage-backed security. But banks buy those because they're yielding a bit higher than treasuries. There are liquid. There's a big market. And the Fed is involved. And that's been part of the reason. Now, as the Fed is reducing his balance sheet and pulling away from that market, the banks are left with buying more.

Now, what's happened during this latest episode was that banks discovered that the duration of a deposit is actually, a lot shorter than what has been estimated. There's been real estimates out on this, that this could be as long as seven years. That's basically the idea of like the three of us have a bank account at XYZ bank. We have a deposit in there. We trust that bank.

We've stayed there for long, many years. And we never really pull our money out unless we absolutely have to. Now what happened in March was obviously people got really worried and pulled their money out really quick. In other words, it's not seven years. It's probably seven hours, right? So if you think of that, the deposit side, the duration much shorter, and you're having a lot of more expect securities on your balance sheet

that can extend the maturity as rates go up, you have this duration mismatch. And that, I think, is the issue here now for banks to have to reassess that gap. And there will be regulatory scrutiny, as you say, coming in here, meaning they're going to be a re-evaluation of banks risk management in the wake of Silicon Valley, obviously. I think what then happens is that you could expect that banks will either decide to sell more mortgage-backed securities or let them run off, like so to speak, just with the Fed did. Either way, more of that supply, quote-called comes on the secondary market in mortgages,

and it has to be repriced at a higher spread. Indeed, nothing to do with the credit risk underlying. It's the government, but much more to do with, I think, the liquidity risk and the bank duration risk. Yeah, super reminiscent of the conversation we had late last year about the sort of broken mortgage market and how banks, you know, they didn't really want to hold a lot of MBS as rates were going up last year. And I can imagine this year, they're even less incentivized to do it. On the mortgage front specifically, I mean, would

that show up in sort of a straightforward higher spreads relative to treasuries? I mean, all things equal in terms of like, okay, banks want to reduce their duration risk. They all saw what happened with Silicon Valley Bank. The regulators come in. Would this be expected to feed through in a sort of straightforward way to cost their mortgages? In some way it does, right? Because it's a market functioning. Yeah. It's a very liquid market.

So people will price in this quote quote higher supply that comes naturally on the market, so to speak. Because this continuous mortgage origination that are packaged in these securities. Then you have to think about what happens also with other investors in this space. So the mutual funds and ETFs and foreign investors, you know, out of four mutual mutual. funds or foreign central banks even or foreign pension funds what they do how they respond now the analysis that's out there there's an expectation that there the man will pick up as that spread implicitly widens yeah you know there will be the money money managers that will find it attractive but i do think let's say on average it should become a wider spread really because banks in the

united states have been the purchaser of these securities in fact with all my notes i brought with me here today Nice. Always love when guests bring data. Yeah. There's data out actually really specifically by entity with own mortgage-backed securities. You have even credit unions involved, community banks, smaller regional banks. They all rely on these mortgage-backed securities in part because their loan book is largely FHA, you know, mortgages, not really non-residential, sorry, not non-agency mortgages. It's largely mostly government-backed loan.

So I think there's that change potentially coming. How much it will be of spread mining is obviously a part of a bit of a market functioning idea as in, you know, who will really be the buyer here. I can imagine that my former colleagues, as I may listen now, hey, you know, you're right, Ben, this is interesting. We can, you know, mortgages are interesting to buy. But that's not going to fill entirely the voice, in my sense, given what the Fed is doing too with their portfolio, which is large, right?

That's a large portfolio of mortgages. So would it be fair to say, summing it all up that, you know, Americans are in for higher mortgage rates thanks to a bunch of, I guess, venture capitalists who built their money out of Silicon Valley? Yeah, maybe on average. Who had their money, who had their portfolio companies money in Silicon Valley Bank, in part so they personally could get lower mortgages from the bank. I don't, you know, that seems to be part of the story.

So thank you. And now we all have to pay higher mortgages. But is interesting. Just to layer on to the irony. Yeah, the interest-only mortgages that they have, right? They originated a low cost and all part of this idea of, yeah, bring all your money in and we'll do more business with you. That's probably going to change to an extent.

Now, I do think pointing to the analysis that Bloomberg put out really good, right, how mapping out where these interest-only mortgages were in California and in the East Coast. Fortunately, that's all high-quality borrowers, right, people that can essentially pay off those loans without a problem, it's not subprime. But nonetheless, I think that market has changed, and that will add to rising cost of credit, I guess. Can we talk a little bit about what we're seeing in terms of collateral? Because, of course, the availability of collateral will affect the availability of credit, because it's the thing that's used to secure a bunch of loans. And we have seen some signs of, like, I don't want to say necessarily,

problems, but maybe weirdness in that market. So I think I wrote about this in the All Lots newsletter, but for instance, the one-month T-bill is yielding like 80 basis points below the effective Fed funds rate, for instance, which is something that you wouldn't expect to see unless there was a big scramble for T-bills at the moment. What is going on there? Yeah, there's, I think, three things happening. So, as you said earlier, the reverse repo facility of the Fed is very large and that has been for a while now and the main reason is that

which are particularly money market funds that are in that facility they cannot purchase enough T-bills. They're out there. So one, it's the Treasury that has an issue more T-bills because of the debt ceiling and their account of the Fed and that dynamic.

We can talk about it in second. Secondly, I think there has been indeed somewhat of a hoarding of these T-bills. If it isn't by those money market funds by our other participants. And then it's about, I think, the way the foreign investors are involved in our markets, because, you know, the latest data I looked up

from the Fed tick data showed actually an increase of holdings of T-bills by foreign central banks or foreign investors, what they call it, which can be others, right? So if you take that together, there is a, I'd say, a limited supply of T-bills in the marketplace, then the Treasury is not issuing enough of it so to speak. By the way, the fat owns about 300 billion of a two, which is not insignificant.

So I think it gives you together a picture of that. And this is statistics, by the way, data on the notes. There's 4 trillion of T-bills outstanding. That's something like 2.2 trillion is pledged as collateral. That's data from the fat. Anything in between is sitting somewhere. Someone's holding it. And so there could be all different entities. I think this is constrained the supply of T-bills. why that yield is lower the effect of the fat. Would you expect that premium to shrink a bit? I mean, I could see like, okay, if it's early March, and you're probably thinking two things,

I don't want to take any duration risk because we just saw a bank get blown out by duration risk, and I don't want to take any credit risk because I just saw a bank collapse. But, you know, as we get, as that recedes in the past, we see some of these emergency functions start to recede again, would you expect some of that to just sort of ease a little bit is people feel a little bit safe to hold something other than, you know, one-month government

securities or something ultra-short? Yeah, and in some ways it's playing out as we speak, right? You know, the spread looks like where we are in 2008, but I don't, that's not the same idea, even though people link it to the bank stress, you know, and parallels to the bank stress are, like, yeah, okay, 0708 showed somewhat similarly events we just went through. But there's a difference maybe that, one, the Fed is much more in position to do. something about it very, really quickly, that's what we saw. And that has definitely diffused part of the crisis.

And as you say, there are a lot of alternatives now in terms of T-bills, right, that people want to invest in, you know, given that where rates are in fixed income. So I think that spread will not be so inverted for now for a long time, but that it is a combination of the technicality of T-bill markets in terms of its supply and what the Treasury is issuing and who's holding it and the dynamic of the Treasury with the debt ceiling. and it's accounted to fat against just a general sense of flight to safety that is temporarily and has receded. You have the desire to help a real difference? The College, LaCity, you offer the program Dependence and Scenta Mental.

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or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. You've been a portfolio manager for a long time, which is one of the reasons we wanted to talk to you about this. But you know, you have experienced various financial crises from a sort of bond perspective. Talk to us about, I guess, what you saw in previous collateral crunches. So 2008, Eurozone. crisis. I mean, I remember writing about the repo market and the role of Eurozone government bonds

in the Eurozone crisis. These were financial crises that were basically caused by collateral problems and a big crunch in that secured lending market. Talk to us about that. Yeah, and that was quite significant in 2008 and 2011. On one hand, it was about people indeed literally hoarding safe bonds and by court-court hoarding them and not lending them out to the repo market, you're getting this repo squeeze, they call it. In other words, you know,

if there's not enough collateral to lend out there and people need their collateral, they have to pay more higher interest as a result. Kind of to the discussion about mortgages. Same idea, the reduction of that supply of mortgages because banks don't want to hold it, pushes up at the cost of borrowing. Then obviously,

the derivatives marketplace is a huge role here because that's experience I had from 2008, it was not just the Lehman moment itself, but it was the recognition that Lehman was such an important play in the derivatives market in terms of collateral agreements that backed those derivatives. And the ISDA agreement, the international security dealer, forgot the term, is there. The swap agreement, there is a collateral agreement. And that's a quite detailed agreement.

It was important there is that if you are managing derivatives in a mutual fund or ETF, the banks that you have that derivative agreement with, you agree on exchanging collateral as margining against the market to market of the position. And in 2008 what happened was that the banks were not in the position to deliver that collateral or vice versa. And that led to this huge crunch. Now, on top came Lehman, which was this big counterparty, obviously, pulling that out of the system, no longer recognizing that who is facing who in the system.

Also, people didn't know, like, where's my collateral? you know, can I get it back? So from the experience of back then with PIMCO, they did a really good job at that time to negotiate those collateral agreements so that the banks had no choice that legally to actually return the cloud unless they absolutely couldn't.

Because there was a lot of that going on too. It was like if you didn't have a good collateral agreement, you would be at significant risk. But all of that contributed to this huge pressure in funding markets and this, what we call collateral shortage. That to an extent, repeated in the euro crisis too, in particularly with German government bonds. And then maybe

last point on that is that this repo market, the repurchase market, what you then get is that, you know, if people cannot or are unwilling to lend out collateral, you get a really defunctional then it's not only that the bonds trade, what they say, special, but you're getting a significant squeeze, right? And that's... I was going to ask, have we seen any like pickup and fails to deliver and things like that in the repo market this time around? Ben's smiling because he has the data right in front of him. Yeah, it's grinning. Grinning, grinning at, you know,

so at 3, 4 a.m. this morning. I did look out that data. The treasury fails. It had picked up, actually, in March. It was a little spike there. So this would be a classic sign of something going on. What does it mean if fails to deliver? They, you buy something and they don't give it to you?

Yeah. It's literally that. It's you know that there's people that are unable to settle securities or settle repo transactions. You can't deliver the bond that you said you would deliver. Why is that not a default? Yeah. Because the repo. Market is special in many ways. And actually, if it would, I mean, Ben can talk about this,

obviously, but if it was considered a default, I think we would suddenly have a major seizure in credit. Because part of what happens is, like, you can kind of on-lend credit that you've been promised. So you get this daisy chain of credit that lubricates the entire market. And if you start breaking the chain by saying this is a default rather than a fail to deliver, then that's a big issue. Ben is showing me some cool charts that he has on his laptop, so we've got to get them and then post them along with this story. You know, I have a question also going back from the portfolio manager perspective. We were talking about mortgages and mortgage spreads. And maybe what is sort of a worse situation for a bank because they don't want to get a tap on the shoulder from a regulator,

maybe that's an opportunity for an asset manager like a PIMCO or something else. In general, how much of the opportunity to pick up alpha, or extra gains for an asset manager, whether it's the size of PIMCO or maybe a smaller one, comes from essentially the constraints that are imposed on other types of potential holders that don't exist for the asset manager. Yeah, what comes to mind immediately is that these securities have a liquidity risk and therefore that's placed into the spread as a risk premium.

Because if the banks are somewhat, quote-called natural holders of these mortgages, as they originate the mortgages, they have mortgage-backed securities, to manage the repayment risk. And so I could imagine that, that therefore the spread could add alpha to your portfolio. The other part of it is more about that it is, again, liquidity, I guess, but it's the dislocation idea.

Like, you know, how do you generate alpha as you jump on these opportunities where there's some level of dislocation? Yeah. And you expect it to reverse, right? And therefore, you're getting price return out of those securities. The other part could be it is that, as much as the Fed is continuing with its quantitative tightening policy,

and I guess the commercial banks have to pull back because of duration risk, that you're getting this more permanent higher level of mortgage back securities yielding higher more permanently, then it becomes an income opportunity, and I could see for that reason certain funds allocate to these type of securities. But from my own experience with mortgages is that the challenge managing them in your own bond portfolio is duration because of the repayment movements. You know, they have convexity. They can sometimes be very positive if rates go up really

quick. But then the other way around, when yield start to decline, the convexity on these securities get quite negative and that could actually adversely shrink your duration of your portfolio versus your index and then your alpha argument isn't really there because you'll be lagging. Yeah. You touched on this already briefly. But I think there's probably more to say, how would you expect the Fed to react to all of this? Because this is also one of the things that is going on at the moment. Seems to be a lot of volatility and almost day-to-day changes in expectations for future hikes, maybe even future cuts. You know, people are trying to figure out what potentially lower credit circulating in the economy actually means for things like inflation.

How would you expect the Fed to handle this? So the one of what they did in March was I think as expected. You know, you're a lender of last resort. You should provide this liquidity. So that term loan facility was a new facility, but it wasn't to me a surprise because the Fed has the ability now to put those up those facilities in 24 hours like Lily. You can like take them off a shelf, basically. Pretty much.

So the market knows this, right? So it means that if we're getting other credit stresses that we saw in March 2020, for example, yeah, would they revisit corporate bond purchase program, commercial paper purchase program and so on. That is an alphabet soup of these facilities. So I think that would be the first reaction. The other reaction is that it is interesting how Lagarde looks at this crisis and saying this is not affecting us, but we're on guard, right?

Because it does correlate with their banking system. If bank stocks go down here significantly, so will they do. So will they in Europe. And the ECB would have to react to that. So that's another, I think, an element of the total reaction function of central banks. Lastly, people will probably look at this by the two-year-healers being so volatile. Will there be a rate cut? Will there be a pause and that sort of idea?

It turns out not, right? It turns out that this was, for the fact, not the reason to shift policy at this point. But it isn't to say that that could be the case. And that's what we've been discussing, right? Yeah, well, that's what I sort of wanted to follow up on specifically. And again, I'm thinking back to how we started the conversation, which is, that sort of measures of total bank credit were at one point the sort of central, the central data points that bond traders would look forward to see where the Fed was and hitting its goals,

etc. And one of the things, you know, we talked about this with Matt King and City recently, which is this sort of return of monetarist thinking on some level, that to what extent is there a sort of clear relationship between the volume of credit, the so-called money supply, and the actual change to the price level that we see in the economy. The idea that money supply and prices were correlated, went out of fashion pretty hard, I would say in the 2010s, but could it come back into fashion? And I don't know, is there, like, how much is the Fed or economists at the Fed looking at these credit numbers as being early warning signals in one way or another about what inflation will be doing three months or six months down the line? Yeah, and I think you touched there on

like how people behave with money. Yeah. Meaning what happened with these deposits at Silicon Valley Bank, for example, and how quickly that went out of Silicon Valley within 48 hours, like, you know, 40, 50 billion or whatever was requested. That's, I think, what they would be looking at, that behavior's changed, that money went elsewhere. It went to money market funds, but part of it is not known where it went.

The data shows only half of the deposit flights went to money market funds. So to your point, the money supply and the money supply and elsewhere, And I actually read the transcript from the early 80s because I was looking at when the rates peak and what was the Fed focused on. And obviously they were focused on M1 and M2. They noted, by the way, back then that M2 and M1 were really rising a lot and that was part of the economy, you know, growing and doing actually well, that this does matter to the Fed today too. Meaning if they don't see in these aggregates significant contraction that points to a change in the economy going another direction, that means that there's money from commercial. or banks that went to money market funds and elsewhere, it's just recycled and gets ultimately out in the economy. So I do think that they pay attention to it because there is that link.

We came out of a pandemic at a production capacity. It was hugely shot off right and had to turn it back on. So that equation, monetarious equation, plays an hour role because if you have price level higher, the production capacity could continue to be higher. The movement of money will ultimately drive in the economy, I think. Because velocity, as funny is that, as tough as that the measure, is probably higher given what's happened with this deposit flight. So if I think of it, Joe, I think of it that within the fact they're going to try to model out, not only what the New York Fed put out the other day, how sensitive deposits are to change

an interest rate, right? That was an interesting research piece. But also then, you know, if people change their mind about holding a deposit of the bank and using it in a different way, say a money market fund, will that alter spending behavior and therefore affect the economy? So the overall dynamic that we're seeing is that deposit flight from banks and rotation into largely money market funds, cash-like instruments, who are then parking it at the reverse repo facility

because they probably don't have enough T-bills to invest in, things like that. Is there a point at which the RRP becomes problematic? for the economy. Like, the Fed created it, I think it was in 2014 or 2013 as a way of better managing interest rate hikes or preparing for interest rate hikes around that time. But is there a point at which like it becomes competition for banks, basically? Yeah, and that may be happening. You know, if you raise rates to a certain level that attracts money to alternatives,

to deposits, and the banks have a hard time, you know, catching up, that announced for New York Fed shows, and we're seeing it through earnings by the way coming through now that banks are adjusting somewhat but not significant enough, then a bloated, a very large reverse repo facility indicates that the money markets are getting way too much money in, that they cannot deploy in T-bills directly and have to go to the FETs facility to get sort of a quasi-tibil there.

They post money at the Fenn and get an interest back on that money. And it's a collateralized transaction, but literally they're getting just interest paid on that money like the T-bill, but that becomes them problematic as much as too that the money markets funds are happy they go out there market

and you know we're higher yields and you know but at some point this creates this I guess this tension in the system just like in 2018

when the Fed discovered like there's a natural level of bank reserves that we cannot go under or we're getting major tension in the system because if we're getting any major tax payments that are not coming in

or cash withdrawals or any sort of that sort of dynamic causes this friction and then they have to do other things at that time they had to actually they bought the bills at that time to try to reverse that situation. In this case you probably

see more of these landing facilities being initiated in order to offset the friction at the reverse repo facility. This kind of, it reminds me of like you know you bring in like a cat to catch a mouse and then you have to bring in like I don't know a dog to catch the cat and then I

like it just keeps going right? It's like one lending facility to fix the 10 or frictions caused by the other lending facility. Yeah, and they've long said that they wanted to use the permanent repo facility as a way to control all of this. But people have said, like, well, you do that, then everything will converge to that facility? Because that's your safest point in the system that you can go to. Right. It's almost like they're creating, like, different tiers of money, right?

Because the RRP suddenly becomes like a specific type of money that's in competition with, like, money in bank. deposits and that sort of thing. But it's considered to be safe, so that's the safest asset you can have, is that reverse repo facility. So it's obviously a really complex issue, not easy to solve. I think for markets, it continues to mean that we're going to face another episode like this for sure. I mean, I think the more that facility grows as one indicator to our earlier discussion,

that's a sign of stress. So just sort of big picture, I mean, we have not seen credit fall off a cliff yet. Like we're seeing some signs of stress, difficult to getting, but it's not going to fall off a clip. Nonetheless, there's something. But it sounds like from this conversation, there's like a few distinct stories. So there was the acute shock at the beginning of March related to Silicon Valley Bank. But also, as you pointed out, like 2021 was just sort of an insane year. And when everyone sort of got drunk on line go up and then some of that naturally has to be unwound.

Then there is the stress of rising rent. creating competition for deposits, and so particularly at the smaller and regional banks, where they may have been doing very well in net interest margins, suddenly they might have higher funding costs if they want to keep their deposit base. Each of these seem like slightly different sort of strange putting stress, but like, how would you sort of, I don't know if weight is the right word, but like sort of like think about all these things we're talking about and sort of like, I don't know, rank them in terms of top of mind or like what sort of the most salient factor here at this point.

in terms of what could drive the availability of credit. Yeah, I do think it is the deposit story. That was, I think, the significant change. Because what it did was that, as we're seeing it coming through the earnings, banks become cautious. So they start to build up reserves. I think there's really important underlying trend there. Against, you know, the fact that you have an economy that's uncertain,

so the opportunities to lend are, by definition, diminishing, right? That's natural, I guess. But I think the fact that the way people responded to what happened at Silicon Valley Bank has woken up in the markets, right, and saying, wait a minute, you have actually an ability to withdraw money so fast, so quick through an app and, you know, the digital age of our money. As you covered crypto a lot, like, that's actually at this time not much to do with this. Yeah, yeah. But it's in the context, right? A digital payment system could cause more shocks going from here is my sort of broader take, I would think. Yeah, it's interesting years that we're waking up.

We did a episode, again, right before SVB with Joe Baldi at Barclays, who put out a note recently talking about SVB waking up so-called sleepy deposits, which is suddenly people waking up to the fact that's like, I can get higher yield and higher safety in one move. Like, what's the catch? This was exactly it. I remember I actually pitched a story idea. It was after our conversation with the New York landlord where he was like,

why do I want to be in the business of renting out apartments when I can get 6% on like a money market fund or like a bank deposit? And I remember pitching a story going, we should do like how higher rates are kind of changing everything. It's like what's the catch? Yeah. It's like no credit, no bank run risk and higher rates. Like who wouldn't want, you know, you could see why a lot of people would wake up to that. That's exactly what we're seeing, right? It's like the reconfiguration of money because of the higher rates that we haven't seen for many, many, many years. Anyway, Ben, we're going to leave it there. But so glad we could have you on. That was an amazing discussion. So thank you so much. Thank you, Tracy. Thanks, Joe. It's really great to be here. Yeah, this is really fun. Thank you so much, Ben. Thank you.

So, Joe, I thought that was fascinating. I can see a headline about, you know, venture capitalist pulling money, causing higher mortgage rates for millions of Americans, just doing absolute numbers in terms of traffic. Maybe we won't do that. But there is something there, right? You know, you have seen this deposit flight set in motion, and it seems natural. to assume that there is going to be some sort of impact on the banks who may pull back from certain markets. No, it's really interesting. And there are like so many, like, different factors. Like, getting a handle on what's going on with credit at any given moment is really tough. And I thought Ben sort of explained why. I mean, one is there is no one credit market. There's bank credit. There's entities like PIMCO, there's private credit. Entities like Apollo, et cetera. So, like, there's no one thing. spreads are different from volume. You have surveys of private borrowers. You have surveys of bank lenders. You're trying to get a handle on it. And it does seem like we're not in like a crisis by any

stretch, but it does seem like money is less freely available than it was maybe several months ago. Well, this is the other thing. I think people naturally, they hear the word credit crunch or the term credit crunch and they think 2008 and they think, you know, sharp, dramatic pullback in credit availability. And that's not necessarily the way it has to play out. You can have these sort of slow-moving crunches that maybe affect certain markets more than others. And I would imagine that's probably what we're going to see. And, you know, again, that's what the Fed's going for in some sense? I mean, what is interest rate policy, but an attempt to make credit more expensive with the goal of slowing the economy for fighting inflation. And so, like, to the extent

that all these things are coming together to put pressure on credit availability, and again, goes back to the Mad King conversation and the sort of like pretty like straightforward return of like monetarist thinking on some level we're watching the plan. Yeah, I mean, it's the reconfiguration of money in the financial system based on these new sort of rates that are available in different ways or at different places. Shall we leave it there? Let's leave it there. Okay. This has been another episode of the All Thoughts podcast. I'm Tracy Allo. You can follow me on Twitter at Tracy Alloway. And I'm Jill Wisenthal. You can follow me on. Twitter at the stalwart. Follow our guest Ben Emmons on Twitter. He's under the handle at Marco

Madness 2. Post a bunch of great charts. Maybe he'll post some of the charts that we talked about today on the show. Follow our producers, Carmen Rodriguez, at Carmen Armin and Dashel Bennett at Dashbot, and check out all of the Bloomberg podcasts under the handle at podcasts. And for more odd lots content, go to Bloomberg.com slash odd lots where we post transcripts. We have a blog, We have a newsletter that comes out every Friday, and go check out our Discord. Listeners hanging out and chatting about all these topics and more 24-7 Discord.g.g. slash oddlots. It's really fun.

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