The Breakdown - The Banking System Broke; Will That Force a Fed Pivot?

Episode Date: March 15, 2023

At this point, markets are racing to figure out what they believe the recent spate of U.S. bank failures means for monetary policy. Will the Federal Reserve stay the course? Will it be forced to pivot on raising interest rates? NLW brings you the debate as well as how the latest CPI inflation data affects the discussion.   

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big-picture power shifts remaking our world. The breakdown is produced and distributed by CoinDest. What's going on, guys? It is Tuesday, March 14th, and today we are asking whether the breakdown in the banking system will force the Fed to pivot. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it. Give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us in the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. All right, guys, it continues to be interesting times, and today was supposed to be the

big financial event of the week with the CPI report. So let's pick up the story from where we left off yesterday and see if the CPI report actually had as much significance as it might once have seemed. So here's where we were. The falling dominoes were Silvergate closing down on Wednesday, Silicon Valley Bank being put into receivership on Friday, and over the weekend, the squawking chaos as the tech industry viewed itself facing moral peril. All of this led to the feds coming in on Sunday night as the white night, saying, hey, we're invoking systemic risk, everyone's deposits are safe,

management is not protected, and taxpayers don't have to foot the bill. Oh, and by the way, we shut down signature bank as well. Yeah, the crypto one. No, don't ask us to explain why. And into all of that on Monday morning, markets started in turmoil. First Republic began the day, 70 plus percent down, and small and regional banks everywhere had their trading halted for volatility. However, then, at least in the non-banking sectors, markets started to recover and even move into the green. Many commentators were incredulous. Dmitri Kofinus from the inimitable Hidden Forces wrote, We got a global pandemic that killed millions of people,

the start of a potential world war that could kill millions more, the steepest interest rate cycle in 40 years, and now the second largest bank failure in U.S. history, and markets are still like, nah, we're going up. And it wasn't just stocks. Crypto absolutely roared yesterday, led by Bitcoin, which was up in New York. nearly 20% on the day, and by the way, has continued to increase today as well, hitting 26,000 at the time of this recording. So what the heck you may ask is going on? Well, let's talk

first about the crypto side. Yesterday I did a YouTube video exploring three possible explanations for why Bitcoin was going up. The first one is the one I'd most like to be true, and that is that this moment is piercing the veil of people's perceptions of the solidity of the banking system and showing them that they are a part of something that is more complex and risky than they might have been led to believe. Even if one isn't clamoring for the destruction of the Fed and the end of fiat money, it certainly strikes us that it might be better if a more informed electorate better understood the part they play, and more specifically the role their money plays in the system we have, so that they have more agency in asserting what they want from that

system. In other words, a better informed electorate equals a better democracy. There were many who jumped on this idea that there was a narrative explanation for the Bitcoin price increase. I quoted Amanda Cassatt, formerly of consensus, now of stertotone yesterday when she said, this may be the first time I've seen crypto go up because of its actual value proposition. Bankless says David Hoffman says crypto prices are up specifically because of what crypto is designed to beat. This doesn't happen often. Blockworks Michaelipalita writes, crypto ripping as banks are failing.

Couldn't have written a better script if you tried. Jack Mahlers of Strike says, we're watching the banking system of the United States collapse on itself in real time. The Federal Reserve may have broken the U.S. banking system and tarnished its credibility. Are we entering a new era for U.S. banking? Will the world now truly appreciate Satoshi and Bitcoin? Stack Hodler says this is a historic pump. Forget the price. On a day when bank stocks are in freefall, Bitcoin is offering safe harbor to those fleeing to basement and counterparty risk. Satoshi's invention is working as intended. Frank Chaparro from the block said literally long Bitcoin short the banks, it's actually happening.

And it's a little beyond scope for now, but there is an interesting sub-dynamic of it being tech entrepreneurs, who are the ones most at risk of the system potentially failing them. Chris Berniske from Placeholder Ventures says a new generation of builders is currently getting a crash course in the flaws and perils of TradFi. Wonder what they'll do next. All right, so narrative explanations. This is one possibility for why Bitcoin has been on the way up. Another is that it's just a market buy from a whale.

On Sunday, Binance CEO, CZ announced that the billion-dollar Binance Recovery Fund would be deploying into liquid crypto token. He tweeted, given the changes in stable coins in banks, finance will convert the remaining of the $1 billion industry recovery initiative funds from BUSD to native crypto, including Bitcoin, B&B, and Eith. Some fund movements will occur on chain. Now, of course, this might have been born of necessity, because shortly afterwards, Coinbase disabled trading of BUSD

as they had previously announced at the end of February. Adam Cochran writes, got to admit CZ plays a good game. He basically just told you he is worried about BUSD to the tune of dumping one billion of it into Bitcoin, but made it seem to say, seem like a good thing and let you front run so there was liquidity. That's some 4D chess right there. Trader Loma Crypto writes, Price is trading as if a Chinese warlord CEO of the number one crypto exchange just announced he was twopping one billion dollar worth of cryptos. Now, one of the things we always talk about on this show is that whenever a price move happens,

as tempting as it is to ascribe it to narrative alone, it almost always has a big dose of market structure in there as well. What's most interesting to me is their interplay. Narrative shifts work on longer timelines than market structure, but market structure wrought shifts, such as liquidations at the right time or finance buying at the right time, can act like a slingshot that makes narrative stronger. I tend to think this is one of those moments. There will have been many people who are noticing a massive move up in Bitcoin as it stared defiantly in the face of U.S. bank failures and politicians who wish it dead. That image, whether the move was caused by CZ or not, makes the narrative of this is what Bitcoin was made for stronger, even if the people receiving that narrative,

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Visit consensus.coindesk.com or check the link in the show notes. Now, as I said, there is a third possible explanation as well, which is that there was a broader shift back to risk on in which Bitcoin was just out ahead of the risk on pack. I mentioned, remember, that stocks were in the green as well, so what might the explanation here be? Pretty simply, it's the same phenomenon that we've seen over and over again since the beginning of this tightening cycle,

which is the market convincing themselves that some broader force is going to force the Fed back into a more accommodative dovish stance. This is the much-fabled Fed pivot. Every other time, markets have convinced themselves of this and rallied on the basis of it, some combination of Fed official comments and new economic data have squashed the optimism. But this time, the reasoning is on a somewhat stronger footing. Fed whisperer Nick Timoros wrote a piece for the Wall Street Journal called Collapse of Silicon Valley Bank, Signature Bank, calls interest rate path into question.

He tweeted the article, adding, There is a saying that the Federal Reserve raises interest rates until something breaks. A big surprise over the past year had been that nothing broke. No more. In the piece, he lays out the incredibly difficult position the Fed is in. On the one hand, they have to address a financial stability issue, but on the other, they have to continue to fight inflation. As Nick writes, quote, the situation could force Fed Chair Jerome Powell and his colleagues into choosing what problem demands the central bank's top focus. Diane Swank, chief economist at KPMG, says, we've always said the one thing that could derail the Fed's tightening would be a financial crisis. It's not clear whether a crisis has been averted yet. And indeed, that is one. one of the big questions. It's clear that as much as politicians make ajorital about one cause or another, the Fed understands that its own tightening cycle has exacerbated if not caused this problem. When the We've Got You announcement came down on Sunday, it was not just an announcement that SVV depositors would be made whole. It was also announcement that the Fed was creating a new lending

facility to hopefully stop the same impairment problems from banks being forced to sell underwater assets. I've gone much more in depth on this on other episodes, so I won't spend too much time on and here, but long story short, one of the key realities of bank balance sheets around the country right now is a duration mismatch between their on-call deposits and the long-duration bonds they bought during the zero interest rate period days. This will be fine as long as there aren't bank runs, but if these banks are forced to sell those bonds, they're going to do so at a loss because they're worth less now that the Fed is giving risk-free money away in the form of treasuries at 4.5%. It is not just signature in Silicon Valley Bank that have this problem. Over $600 billion

of unrealized losses currently sit on bank balance sheets, and the Fed is hoping through this new lending facility to allow banks that need liquidity to be able to borrow against those loans from the Fed instead of having to sell those loans and realize the losses. Now, there are tons of questions that surround this lending facility. First, is it enough? Second, will it be exploited? I've seen lots of folks talk about the new trade opportunities that the lending facility opens up. But still, when it comes to Fed policy, it seems like one possible reason that they wanted to set up this facility so early in the crisis process is that they wanted to be able to continue to hike rates without further breaking things. Here's again how Nick Timoros put it. Quote,

Fed officials have at times over the past year acknowledge the risk of being forced to simultaneously fight two problems, financial stability fallout and inflation. Several have said they would use emergency lending tools along the lines of the bank funding facility of the Fed unveiled Sunday to fight the former so they could continue to raise interest rates or hold rates at higher levels to fight the latter. Fed Governor Christopher Waller said in a speech last October, quote, I believe we have the tools in place to address any financial stability concerns and should not be looking to monetary policy for this purpose. The focus of monetary policy needs to be fighting inflation. Now, markets have been pretty volatile when it comes to predicting

what the Fed would do next. A few days ago, following an appearance from Jerome Powell at congressional hearings, the markets were in the process of fully pricing in a 50 basis point hike at next week's FOMC meeting. The sentiment has now sharply reversed, with markets now forecasting a 25 basis point hike with a 69% probability and attaching a 31% chance that the Fed will take a pause. Note this was this morning before the CPI numbers. The most probable path now is for the Fed to hit a terminal rate of 5% this month before beginning to cut rates in September, that's again, according to traders. Bon markets are sending an even more dramatic message. On Monday, the interest rate on two-year treasuries plunged by more than 60 basis points, touching a low of 3.8%

before correcting back to 4%. That's a move 31 standard deviations away from average volatility. Last week, the two year was firmly priced at 5%, indicating a market acceptance that the Fed would pursue a higher terminal rate in the face of economic data pointing towards re-accelerating inflation. Still, a lot of the Troutify world is sort of of the mind that, when the dust settles and we move away from the shrieking all-caps venture capitalists on Twitter, and SVB depositors are protected and the new lighting facility is up and running,

that these bank failures will be seen as a warning shot, but not an existential threat. and the Fed will continue on its way. Former trader at Goldman Sachs, Michael Cow, says, don't conflate deposit a ring fencing with a return to the liquidity lottery. Consider yourself forewarned. Dear Fed pivoters, when you zoom out and look at the big picture, does this look like the picture of financial stress that derails what the Fed has been trying to do for the last 15 months?

It's as if people have completely forgotten the 2007-2008 period. This is nowhere close. Writer Nathan Tankis points out that stock market volatility does not actually a crisis make. He writes, Does anyone have any other data points on what's going on with mid-sized banks? It doesn't seem like they've had very much deposit outflow. The main sign of distress seems to have been the stock prices,

but that was an obvious trade to lock in Sunday regardless of Fed and FDIC action. Stock traders are not bond traders who are not bank balance sheet analysts. The conventions among one group doesn't necessarily travel to the others, and seems to me the stock market behavior is segmented from the financial situation in this case. Yet still there's no doubt that the Fed is in a tough place. Huff, the co-founder repair protocol, right? Fed is stuck between a rock and a hard place. If they continue hell-bent on raising rates to tame inflation, the same assets on these balance sheets will cause an even bigger hole. Hence why I think 50 basis points

hike is off the table. At the same time, if they pause or cut, it undermines Fed credibility. The one thing they cannot afford to lose if they want to run a low inflation mandate. So do we have any evidence that we can glean from the past in terms of what Powell has said that might suggest where they're going to come out on this particular question? I think the biggest thing are repeated comments from Powell to the effect that it doesn't ultimately really matter how fast the Fed gets to the terminal rate. It's far more important to get there in a manner that allows the Fed to maintain a higher rate for longer.

To me, that might suggest for a moderate path, certainly 25 basis points over 50 basins points, and even perhaps an argument for a pause to take a breath. And all of this brings us back to the question of data on the inflation side and where it's pointing. As for the actual CPI forecast, Wall Street analysts were, forecasting headline CPI for February to come in at 6%. A significant decrease from the 6.4% recorded in January. 6% would have been the slowest annual increase in September 2021, and definitely a sign that things have been moving in the right direction. Core CPI, which strips out food and

energy, was anticipated to register a 5.5% annual increase, which would be a slight downtick from January's 5.6. Prior to the events of the last week, it was anticipated that this inflation print would be viewed as signs that the Fed is not making enough progress on inflation with their current policy. However, now, after SVB and everything that's happened, a CPI reading consistent with this slow and steady decline in inflation might have given the Fed just enough space to take a breath and ensure that no more banking sector failures float to the surface in the coming month. So what did we get? Well, honestly, it was pretty muted and pretty much in line with expectations. Headline CPI was 0.4% month over month, just as expected. Core year over year was 5.5% just as expected.

and the only miss where inflation came in a bit hotter than expected was that economists expected core CPI month over month to go up 0.4%, but instead it went up 0.5%. Still, 70% of that was due to shelter, which is such a lagging indicator that it seemed not really to freak markets out. Futures were up after the announcement and the bond market moved to price a 25 basis point hike at a 76% chance next week. What's more, as I intimated at the beginning, Bitcoin is up above 26,000.

So in the end, the question is, will this be a price? CPI reading actually matter in terms of what the Fed does at the next FOMC meeting. David Ingalls and editor at Bloomberg writes, Goldman Sachs no longer sees the Fed raising interest rates next week due to the recent stresses in the banking sector. Big call. Goldman economists have basically said CPI print is a non-event now. Trader Johannes Borgon says Deutsche Bank has a new astonishing forecast for the next ECB and Fed meetings. Quote, absolutely no idea at the moment what the Fed and ECB are going to do at their meetings over the next week and even beyond. At least that's honest. My base case, is that there will be no pivot.

The fight against inflation is too tenuous, and frankly, I think the Fed knows that its credibility is even more tenuous. Right now, the bank lending facility that they set up does not, despite the inflamed tweets of the overly excited, look to most people like another version of QE, even if in some ways it functionally acts like it. It instead appears like the Fed trying to solve a negative externality and consequence of a tightening cycle that they have conviction needs to continue. In other words, it doesn't strike most people as the Fed going back.

against themselves, it looks like a Fed who wants to keep tightening, recognizing that as they squeeze, this problem of unrealized losses on bank balance sheets is something that needs to be addressed along the way so that they can continue. Now, all that said, I do think that the extreme end of their possibility set has been tamped out. I would not expect us to see any more jumbo hikes of 50 basis points or more. Then again, the whole point right now is that no one knows anything because we don't know until things happen, and there weren't a lot of people who are predicting the last two weeks, two weeks ago. So there you have it, guys. That's the story from the CPI. That's the story from the Fed Pivot world. As always, I appreciate you listening. And until tomorrow, be safe and

take care of each other. Peace.